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Thursday, September 3, 2009

Hedging loans with interest rate futures

Interest rate futures (IRFs), which made a comeback this Monday after six years, has opened up a lot of interesting options for an individual.
Especially, for high networth individuals (HNIs), IRFs could be a good hedge against loans or existing fixed deposits. Here’s how it will work:
Say, a person has taken a home loan of Rs 40 lakh at 8 per cent floating rate for 15 years. His equated monthly instalment (EMI) would be Rs 38,226.

Home loan = Rs 40 lakh
Rate of interest = 8 per cent
Tenure = 15 years (180 months)
EMI = Rs 38,226
After one year
Rate of interest = 10 per cent
Principal outstanding = Rs 39,77,919
Tenure = 14 (168 months)
New EMI = Rs 44,083
(increase = Rs 5,857)
Hedging through IRFs
Twenty lots of IRFs = Rs 40 lakh
Margin money (5 per cent) = Rs 2 lakh
Sold after one year (at 1-1.5 per cent higher yield) = Rs 2.4 lakh - Rs 3.8 lakh (considering 1 per cent rise yield leads to returns of 6 per cent due to fall in price)
Prepayment of loan
(entire Rs 2.4 lakh)

New Balance = Rs 37,37,919
New EMI = Rs 41, 424
Saving = Rs 2,659 per month

If the interest rate goes up to 10 per cent next year, the outstanding principal will be Rs 39,77,919 and the fresh EMI will come to Rs 44,083 - a rise of Rs 5,857 per month.
Supposing the person was expecting the rate to go up, as is the case now where there are expectations that any rise in inflation would result in higher rates, he can sell IRFs (go short) in the futures market for the same time frame (one year) now to hedge against this risk.
The instrument will be a 10-year notional coupon bond bearing the Government of India security. Since one contract size of IRF is Rs 2 lakh, he needs to deal in 20 lots.
After one year, when home loan rates rise, benchmark yields of the notional coupon would also have increased (earlier in fact, to indicate a rising interest rate regime). Consequently, the yields of IRFs would also rise.
If one considers that yields of IRFs will rise by at least 1 per cent to 1.5 per cent to trigger a 2 per cent rise in home loan rates, the seller of IRFs is going to earn around Rs 2.4 lakh to Rs 3.8 lakh (assuming that 1 per cent rise in interest rate leads to a return of 6 per cent due to fall in prices).
If he partly pre-pays his loan using the profit, his EMI would come down by Rs 2,659. If the interest rate does not go up, he will not make any money on IRFs, but his EMIs will stay constant. On the other hand, if the interest rate goes down, he stands to lose money on IRFs, but his EMI will also come down.
However, while it is possible to hedge your loan against a rise or fall in interest rates, the correlation between IRFs and mortgage rates is not absolute.
Importantly, investors will need margin money for buying the contract and pay for transaction costs.
While the National Stock Exchange is not charging anything at present, the financial institution could charge around Re 0.02 to Re 0.03 per contract.


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