NISM Series V-D · Chapter 22: Strategies using Interest Rate Derivatives

L1 · Foundation

Foundation — The three participants and the four hedging structures

Hedgers, speculators and arbitragers and what each brings to the market, the three parameters to select before any trade, the short hedge with its three-scenario comparison, duration-based portfolio hedging, hedging future borrowing, and the long hedge.

16 min read · Worth 4% of the paper · Written from pages 563–596 of the official NISM workbook · Updated 18 September 2026

22.1 The three market participants

Hedgers

"Hedgers are traders who wish to PROTECT THEMSELVES from the risk involved in price movements of underlying... These types of participants have a REAL EXPOSURE to interest rate risk on account of their UNDERLYING BUSINESS and their objective is to REMOVE the interest rate risk using Exchange Traded Interest Rate Derivatives."

"Since interest rates and bond prices are INVERSELY related, the risk associated with a RISE in interest rates causes bond prices to FALL, and vice versa. Bond investors, specifically those who invest in LONG-TERM FIXED-RATE bonds, are MORE DIRECTLY SUSCEPTIBLE to interest rate risk."

The chapter's illustration: an entity invests Rs 10 crore in 6.10% 10-year GOI securities, paying Rs 61,00,000 per year. If rates rise to 6.50 per cent, a new bond would pay Rs 65,00,000. "If the 6.10% bondholder continues to hold his bond through maturity, he LOSES OUT ON THE OPPORTUNITY to earn a higher interest rate. Alternatively, he could sell... However, doing so results in the investor getting a LOWER PRICE on his sale." Either way he is hurt — which is precisely why he hedges.

Speculators

"This set of market participants DOES NOT HAVE A REAL EXPOSURE... These participants ASSUME interest rate risk by TAKING A VIEW on the market direction."

"Speculators play a VITAL ROLE in the ETIRD markets. 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. Speculators, or traders, ASSUME THE PRICE RISK THAT HEDGERS ATTEMPT TO LAY OFF... hedgers often DEPEND ON SPECULATORS TO TAKE THE OTHER SIDE OF THEIR TRADES (i.e., act as counter party) and to ADD DEPTH AND LIQUIDITY."

The wheat example returns here from Chapter 19, with the trader added: the farmer wants to sell futures, "In order to sell this futures contract, HE NEEDS A BUYER", which may be a flour mill or bakery. "However, most of the times, there is a DEMAND SUPPLY MISMATCH in the market and THE TRADER FILLS THE GAP. Here trader... is thinking in CONTRARY i.e., this buyer will buy only if he thinks that actual price of wheat is going to be HIGHER than the contract price."

Arbitragers

"to ESTABLISH A LINK BETWEEN VARIOUS MARKETS like spot and derivatives, we need a third type of participants... These arbitragers CONTINUOUSLY HUNT for the profit opportunities ACROSS THE MARKETS AND PRODUCTS and seize those by executing trades in different markets and products SIMULTANEOUSLY. Importantly, arbitragers GENERALLY LOCK IN THEIR PROFITS UNLIKE TRADERS WHO TRADE NAKED CONTRACTS... They have NEITHER EXPOSURE TO RISK AND NOR DO THEY TAKE THE RISK."

"As more and more market players will realize this opportunity, they may also implement the arbitrage strategy and in the process will ENABLE MARKET TO COME TO A LEVEL OF EQUILIBRIUM and the arbitrage opportunity MAY CEASE TO EXIST."

The worked example, 1 January 2020 — spot Rs 100, March futures Rs 110, lot size 50. "an arbitrageur will buy in the cash market at Rs 100 and sell in the Futures market at Rs 110, thereby LOCKING Rs 10 as his profit on each unit."

	Underlying settles at 108	Underlying settles at 95
Cash market	Buy 100, sell 108 → +8	Buy 100, sell 95 → −5
Futures	Sell 110, buy 108 → +2	Sell 110, buy 95 → +15
Total per unit	+10	+10
Total profit	10 × 50 = Rs 500	10 × 50 = Rs 500

"In the entire activity, the TRANSACTION COST, IMPACT COST, CARRY COST/OPPORTUNITY COST/BORROWING COST, etc. HAVE NOT BEEN CONSIDERED. In real life, ALL THESE COSTS HAVE TO BE CONSIDERED."

The arbitrager's own risks: "there is a possibility of SOME GAP BETWEEN THE EXECUTIONS of both the orders. If either leg of the transaction is ILLIQUID then the risk on the arbitrage deal is HUGE as ONLY ONE LEG MAY GET EXECUTED and another may not, which would open the arbitrager to the NAKED EXPOSURE of a position." And: "if contracts are NOT CASH SETTLED in both or one of the markets, it would need REVERSAL OF TRADES."

But: "These profit focused traders and Arbitragers FETCH ENORMOUS LIQUIDITY to the products traded on the exchanges. This liquidity in turn results in BETTER PRICE DISCOVERY, LESSER COST OF TRANSACTION and LESSER MANIPULATION in the market."

22.2 The three parameters to decide

"For hedging and/or trading, we must decide THREE PARAMETERS: (1) INSTRUMENT; (2) MARKET SIZE; and (3) CONTRACT MONTH."

Parameter	Selection rule
Instrument	"Linked to TENOR of rate being traded. For 3M rate, use T-Bill futures. For 10Y rate, use 10Y GOI Bond futures/Option"
Market side	"Linked to EXPECTED CHANGE IN THE DIRECTION OF RATE"
Contract Month	"Linked to WHEN we expect the change in rate to occur. The timing of expected change in rate should be THE SAME AS CONTRACT MONTH"

"T-Bills price is determined by short-term rate of THREE MONTHS (because the underlying has a maturity of 91 days) and GOI Bond price is mainly determined by LONG TERM RATE (assuming underlying is a 10Y bond)."

The market side table — memorise this

Interest rate expectation	Market side	Position
Interest rate will INCREASE	LONG on interest rate	SELL GOI bond futures; BUY GOI bond PUT option; SELL T-Bills futures; BUY Overnight MIBOR futures
Interest rate will DECREASE	SHORT on interest rate	BUY GOI bond futures; BUY GOI bond CALL option; BUY T-Bills futures; SELL Overnight MIBOR futures

Note the crucial reversal within the same row: "if underlying instrument is overnight MIBOR future, then for expectation of short-term rate will INCREASE we should go LONG on overnight MIBOR future" — because MIBOR futures are quoted in interest rate, whereas bond and T-Bill futures are quoted in price.

The chapter's own worked case: "if participant wants to BORROW money after 3 months, they will have risk of interest rate INCREASING. In such case they will take LONG position on interest rate. Now for hedging this risk through single bond interest rate futures, participant will SELL futures (due inverse relation between interest rate and price of bonds), however if participant wants to hedge the risk through MIBOR futures, participant will go LONG on MIBOR futures."

"Hedging with futures can be implemented by undertaking a futures position as a TEMPORARY SUBSTITUTE for transactions to be made in the SPOT MARKET AT A LATER DATE. If cash and futures prices move together, ANY LOSS realized by the hedger from one position WILL BE OFFSET BY A PROFIT ON THE OTHER."

22.2.1 Short hedge

"A SHORT HEDGE is used to PROTECT AGAINST A DECLINE IN THE CASH PRICE of a fixed income security. To execute a short hedge, FUTURES CONTRACTS ARE SOLD. By establishing a short hedge, a hedger has FIXED FUTURE CASH PRICE and TRANSFERRED THE PRICE RISK OF OWNERSHIP to the buyer of the futures contract."

The example, 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 the investor expects yields to rise, plus "expecting new bond issuance in October 2021 with a HIGHER COUPON rate." Three choices:

I. Sell bond now and invest in short maturity paper (T-Bills @ 3.20%)
II. Hold bond till October 28, 2021
III. Hold bond and hedge with interest rate futures

"As investor holding a bond, he is LONG on debt securities and SHORT on interest rate. Investor is exposed to risk of increasing interest rate. So, Investor should go LONG on interest rate by taking SHORT position in bond futures." He sells October 2021 expiry futures at Rs 99.95, and "since one contract is of notional value of Rs 200000, investor will sell 250 lots (= Rs 5 Crores / Rs 2 lacs)."

On expiry, 28 October 2021, the bond is at Rs 98.36 (yield 6.32%).

	Scenario I — sell now, buy T-Bills	Scenario II — hold the bond	Scenario III — hold and hedge
Clean price	Rs 100	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)
Cash/bond value	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
Amount available on expiry	Rs 5,07,53,106.22	Rs 5,00,86,527.78	Rs 5,08,81,527.78

	Advantage	Limitation
Scenario I	"Avoid interest rate risk by investing in short term paper"	"Loosing on ACCRUED INTEREST"
Scenario II	"Accrued interest on holding security; beneficial if price of bond increase"	"Expose to interest rate risk"
Scenario III	"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 cash settled); OPPORTUNITY LOSS in case of increase in GOI price"

"Similarly, a fund manager knows that bonds MUST BE LIQUIDATED IN 45 DAYS to make a payment to beneficiaries. If interest rates rise during the 45 days, MORE BONDS NEED TO BE LIQUIDATED at a lower price... To protect against this possibility, fund manager can sell bond futures to LOCK SELLING PRICE."

22.2.2 Portfolio-based hedging

"in reality the investors/bond holder will hold MULTIPLE BONDS OF DIFFERENT MATURITY and interest rate futures MAY NOT BE AVAILABLE ON ALL THESE BONDS. How will investor hedge?"

"A DURATION-BASED HEDGE RATIO is a hedge ratio constructed when interest rate futures contracts are used to hedge positions in an INTEREST-DEPENDENT ASSET... investor may hedge the portfolio or part of the portfolio on WEIGHTED AVERAGE MODIFIED DURATION BASIS."

"The above ratio can be used to make the DURATION OF THE ENTIRE POSITION ZERO."

The worked example: portfolio Rs 26 crore, portfolio duration 6.1; futures duration 4.7; one-month futures price Rs 98.50.

"The LIMITATION of employing a duration-based hedging strategy has much to do with the fact that DURATION MEASURES ARE ONLY ACCURATE FOR SMALL CHANGES IN YIELD. For LARGE changes in yield, the price/yield relationship is NOT LINEAR BUT IS ACTUALLY CONVEX. Thus, using the strategy in the face of large moves in yield will result in 'UNDERHEDGING'. Further, the price of portfolio & futures contract MAY NOT MOVE IN TANDEM leads to BASIS RISK."

22.2.3 Hedging future borrowing

"a corporate wants to issue NCDs for 10 years AFTER 1 MONTH. Generally, they are able to borrow at 50 basis point SPREAD OVER THE G-SECS. In such case the Institution SELLS IRF contracts to hedge against the rise in interest rates."

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

"The Institution gains Rs 0.80 (= 95.60 − 94.80) per bond in IRF. Hence, borrowing cost for institution will REDUCE TO THE EXTENT OF ITS GAIN in IRF. The Institution has EFFECTIVELY LOCKED ITS BORROWING COST AT LOWER RATE. Please note that, this will NOT PROVIDE PERFECT HEDGE... as the UNDERLYING INSTRUMENTS ARE DIFFERENT and hence there will be a BASIS RISK."

22.2.4 Long hedge

"Long hedges are usually initiated by traders who INTEND PURCHASING AN ASSET IN THE FUTURE and are concerned that PRICES MAY RISE in the interim period... investors want to invest in fixed income securities in future and are concerned that the interest rate will go DOWN in future (i.e., prices may RISE)... In a long hedge, the hedger BUYS a futures contract to LOCK IN PURCHASE PRICE / YIELD."

"An insurance company's Fund Manager may use a long hedge when substantial cash contributions are expected... Also, a bond trader who knows that BONDS ARE MATURING in near future and expects that interest rate will fall can employ a long hedge."

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

On 26 March (expiry) the bond is at Rs 101.58 (yield 6.23%):

If physically settled: "the fund manager will receive the bond at Rs 99.60 with yield of 6.51%"
If cash settled: "profit from future... Rs 3.96 Crores { = (101.58 − 99.60) × 10000 lots × 2000 units } which can be invested in bond to earn higher interest/yield"

And the cost of hedging, stated honestly: "The REDUCTION IN RISK provided by hedging ALSO TYPICALLY RESULTS IN A REDUCTION IN POTENTIAL PROFITS." Had the bond instead been at Rs 99.00 (6.59%) on expiry, "the insurance company will have loss from the futures position... Rs 1.20 Crores { = (99.60 − 99.00) × 10000 × 2000 } which will REDUCE THE OVERALL RETURN."

The option alternative: "the maximum risk to the buyer of an option is LIMITED TO THE PREMIUM PAID. So, in case of long hedge the company may buy GOI bond CALL option... Similarly, for short hedge and hedging future borrowing the company hedge by buying GOI bond PUT option."

Think of it like this

Hedgers need speculators, and the book says so plainly

It is fashionable to treat speculators as parasites on a market. The chapter refuses to: "Derivatives are designed primarily to assist HEDGERS... HOWEVER, THIS WOULD NOT BE POSSIBLE WITHOUT THE PARTICIPATION OF SPECULATORS." Someone must take the other side. When the farmer wants to sell wheat forward and no miller happens to want it that week, "the TRADER FILLS THE GAP between demand and supply" — and he does it only because he believes the opposite of what the farmer believes. The market needs disagreement to function.

The arbitrager earns Rs 500 whatever happens

The chapter's arbitrage table is worth staring at. Buy spot at 100, sell futures at 110. If the underlying ends at 108, the cash leg makes +8 and the futures leg +2. If it ends at 95, the cash leg loses 5 and the futures leg makes +15. Both come to exactly +10 per unit, Rs 500 on 50 units. The direction of the market is irrelevant — which is why "arbitragers GENERALLY LOCK IN THEIR PROFITS UNLIKE TRADERS WHO TRADE NAKED CONTRACTS." The profit was fixed the moment both legs were executed.

MIBOR futures run the opposite way to bond futures

The single most confusing line in this chapter, and it is examined. Expecting rates to rise? For bond futures you SELL; for MIBOR futures you BUY. Why? Because bond futures are quoted in price and MIBOR futures in interest rate itself. Rising rates push bond prices down, so you short the price; rising rates push the MIBOR quote up, so you go long the rate. It is the same view expressed in two different currencies of quotation — like saying "the rupee is weakening" and "the dollar is strengthening."

Three doors, and the hedge wins on the numbers

Investor X's three scenarios are unusually satisfying because the chapter actually totals them: Rs 5,07,53,106 if he sells and parks in T-Bills; Rs 5,00,86,528 if he simply holds; Rs 5,08,81,528 if he holds and hedges. The hedge wins because it collects both the accrued interest of holding and the futures gain of Rs 7,95,000. Selling out earns T-Bill interest but "loses on ACCRUED INTEREST" of the higher-coupon bond. Doing nothing keeps the coupon but eats the price fall in full.

Duration hedging is a weighing scale, not a photograph

The duration-based hedge ratio matches the rate sensitivity of your portfolio against the rate sensitivity of the futures contract — Rs 26 crore at duration 6.1 needs 1713 lots of a contract with duration 4.7. But the chapter is careful about what this cannot do: "DURATION MEASURES ARE ONLY ACCURATE FOR SMALL CHANGES IN YIELD. For LARGE changes... the price/yield relationship is NOT LINEAR BUT IS ACTUALLY CONVEX. Thus... will result in UNDERHEDGING." It is a scale calibrated for small weights; load it heavily and it under-reads.

The NCD issuer hedges a bond he has not yet issued

A corporate planning to issue 10-year NCDs after one month at "50 basis point SPREAD OVER THE G-SECS" has an exposure that does not exist yet — and hedges it anyway by selling IRF. When futures fall from 95.60 to 94.80, it "gains Rs 0.80 per bond" and "borrowing cost... will REDUCE TO THE EXTENT OF ITS GAIN." But note the honesty: "this will NOT PROVIDE PERFECT HEDGE... as the UNDERLYING INSTRUMENTS ARE DIFFERENT and hence there will be a BASIS RISK." He is hedging corporate credit with government paper — close, not identical.

A hedge cuts both ways, and the chapter shows the losing case

Most textbooks show hedges only when they work. This one deliberately does not: after the insurance company makes Rs 3.96 crore on its long hedge, the chapter runs the alternative where the bond closes at Rs 99.00 and the position loses Rs 1.20 crore, "which will REDUCE THE OVERALL RETURN." And it states the principle: "The REDUCTION IN RISK provided by hedging ALSO TYPICALLY RESULTS IN A REDUCTION IN POTENTIAL PROFITS." That is Chapter 19's definition of hedging — locking the return at a known level, not a good one.

When you want the upside too, buy the option instead

The chapter ends its hedging section with the escape hatch: "the maximum risk to the buyer of an option is LIMITED TO THE PREMIUM PAID. So, in case of long hedge the company may buy GOI bond CALL option... for short hedge and hedging future borrowing the company hedge by buying GOI bond PUT option." Futures lock the price and forfeit the favourable move; a bought option keeps it for a fee. It is exactly Chapter 19's hedging versus insurance distinction, now with specific instruments attached.

Key terms in this chapter

Arbitrager: A participant who identifies mispricing and executes simultaneous opposite trades in two or more markets. Arbitragers generally lock in profits, unlike traders who trade naked contracts.
Basis risk: The risk that the price of the hedged portfolio and the price of the futures contract do not move in tandem, leaving the hedge imperfect.
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.
Bearish vertical spread using puts: Long a higher strike put and short a lower strike put to reduce cost. Maximum profit when bond prices fall and both options are exercised.
Bullish vertical spread using calls: Long a lower strike call and short a higher strike call. A net cash outflow position with limited profit and limited loss.
Bullish vertical spread using puts: Short a higher strike put and long a lower strike put. A net premium receipt strategy, with maximum profit when both options expire unexercised.
Butterfly spread: A neutral strategy combining bull and bear spreads, using four options and three strike prices, with fixed risk and capped profits and losses.
Calendar spread: Buying one month's contract and selling the same contract of a different month. It has no directional risk on the underlying, only basis risk on the spread, so margins are much lower.
Changing portfolio duration: Fund managers adjust portfolio duration to act on rate expectations. Futures are a quick and less expensive way to do so: buying GOI bond futures increases portfolio duration and selling reduces it.
Covered call: Holding the bond and selling a call against it. A strategy that sells volatility in return for fees, generating extra income other than coupon without selling the bond, but capping the upside.
Diagonal spread: Options on the same underlying with different expiries and different strikes. Much more complicated in nature and execution, with no drawable payoff.
Duration-based hedge ratio: The hedge ratio for a portfolio of many bonds: portfolio duration times market value, divided by futures duration times futures price over par. It makes the duration of the entire position zero.
Execution risk: The risk that prices move between placing the two legs of a spread as separate orders. It is avoided by using the exchange spread order facility.
Fisher-style borrowing spread: Corporates typically borrow at a spread over G-Secs, in the chapter's example 50 basis points, which is why selling G-Sec futures hedges a future NCD issue imperfectly but usefully.
Hedger: A participant with a real exposure to interest rate risk from underlying business, whose objective is to remove that risk using derivatives.
Horizontal spread: Same strike, same type, different expiry. Also called a time spread or calendar spread. No payoff chart can be drawn because the expiries differ.
Imperfect hedge: A hedge that does not fully offset the exposure, arising from standardised expiry dates, limited available underlyings, and cash settlement timing or price mismatch.
Inter-bond spread: A long-short position in futures on different underlying GOI bonds, typically of the same expiry, used when anticipating steepening or flattening of the yield curve.
Leverage in IRF: With 5 per cent margin a trader can leverage about 20 times, multiplying profits and losses alike. A futures position earns no accrued interest, unlike holding the bond.
Long call butterfly: Buy 1 ITM call, sell 2 ATM calls, buy 1 OTM call at equally spaced strikes. A bet on very low volatility, risk limited to net premium paid.
Long hedge: Buying futures to lock in a purchase price or yield, used by those who intend to buy an asset in future and fear that prices will rise (rates fall).
Long straddle: Buying a call and a put at the same strike and expiry. Used when direction is uncertain but a significant move is expected. Two break-evens at strike minus and strike plus total premium.
Long strangle: Buying an out-of-the-money call and an out-of-the-money put at different strikes. Cheaper than a straddle but needs a larger move to profit.
Market side rule: Expecting rates to rise means going long on interest rate: sell GOI bond futures, buy bond puts, sell T-Bill futures, but BUY Overnight MIBOR futures, since MIBOR futures are quoted in rate not price.
Naked exposure: The position an arbitrager is left with when only one leg of a two-leg trade executes, typically because one leg is illiquid.
Protective put: Holding the bond and buying a put. It lets the investor stay in the market, reduce losses to the premium paid, and still gain from the upside.
Regular arbitrage: Buy the bond in the underlying market and sell futures on the same bond. Generally possible when the futures price is above the theoretical futures price.
Reverse arbitrage: Sell the bond, lend money in the repo market against it, and buy futures. Generally possible when the futures price is below theoretical, but short selling G-Secs is not permitted to all participants.
Short hedge: Selling futures to protect against a decline in the cash price of a fixed income security, fixing the future cash price and transferring price risk to the futures buyer.
Short straddle: Selling a call and a put at the same strike and expiry, to profit from premiums when the market is expected to remain stable. Loss potential is unlimited.
Short strangle: Selling two out-of-the-money options, profiting if the market stays between the strikes. Maximum profit is the combined premium; loss is unlimited in both directions.
Speculator: A participant with no real exposure who assumes interest rate risk by taking a view on market direction. Speculators take the other side of hedgers' trades and add depth and liquidity.
Spread order facility: An exchange facility that executes both legs of a spread together, removing the execution risk of placing two separate orders.
Synthetic security: A cash security created by combining a bond position with a futures position. Long a 15-year bond plus short a 3-month future on it creates a synthetic 3-month T-Bill.
Three trading parameters: Instrument (linked to the tenor of the rate), market side (linked to the expected direction of rates) and contract month (linked to when the change is expected).
Underhedging: The result of using a duration-based hedge when yields move a lot, because duration is accurate only for small changes while the price-yield relationship is actually convex.
Vertical spread: Options with the same expiry but different strike prices, created using calls or puts, in bullish or bearish form.
Yield enhancement: Realising a higher return by creating a synthetic short-term security when its yield exceeds the cash market yield for the same tenor.

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

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