NISM Series IV: Strategies Using Exchange Traded Interest Rate Derivatives

NISM Series IV: Strategies Using Exchange Traded Interest Rate Derivatives

Welcome to Part 6 of our NISM Series IV Interest Rate Derivatives complete study notes. This post covers Chapter 5 — Strategies Using Exchange Traded Interest Rate Derivatives. This chapter is practical and strategy-heavy. You need to understand when and why different strategies are used, as they are commonly tested in the NISM derivatives certification exam.

Types of Market Participants — A Recap

Three types of participants use exchange-traded interest rate derivatives:

1. Hedgers

Hedgers are traders who wish to protect themselves from the risk involved in price movements of the underlying (interest rate or interest rate instruments). These participants have a real exposure to interest rate risk from their underlying business. Their objective is to remove interest rate risk using exchange-traded interest rate derivatives.

2. Speculators

Speculators do not have a real exposure to interest rate risk. They assume interest rate risk by taking a view on the market direction and hope to make returns by taking the price risk.

3. Arbitrageurs

Arbitrageurs continuously hunt for profit opportunities across markets and products and seize those by executing trades simultaneously. Importantly, arbitrageurs generally lock in their profits unlike traders who trade naked contracts. They identify mispricing in the market and use it for making profit.

Hedging Through Exchange Traded Interest Rate Derivatives

For hedging and/or trading, you must decide three parameters:

1. Instrument — Which derivative to use.
2. Market Size — How many contracts to trade.
3. Contract Month — Which expiry to trade.

Portfolio-Based Hedging

A duration-based hedge ratio is used when interest rate futures contracts are used to hedge positions in interest-dependent assets (usually bonds or money market securities).

To reduce interest rate risk in a debt portfolio, an investor may hedge the portfolio (or part of it) on a weighted average modified duration basis using Interest Rate Futures (IRFs).

Hedge Ratio Formula:

Number of Contracts = (Portfolio Modified Duration × Market Value of Portfolio) / (Futures Modified Duration × Futures Price / PAR)

This ratio can be used to make the duration of the entire position zero, effectively eliminating interest rate risk.

Option Trading Strategies Option Spreads

Spreads involve combining options on the same underlying and of the same type (call/put) but with different strikes and maturities. These are limited profit and limited loss positions. They are categorized into:

• Vertical Spreads
• Horizontal Spreads
• Diagonal Spreads

Vertical Spreads

Vertical spreads are created using options having the same expiry but different strike prices. They can be created using calls or puts.

Bullish Vertical Spread (Bull Spread)

A bull spread is created when the underlying view on the market is positive (bullish), but the trader would also like to reduce his cost on the position.

• Bull Call Spread — Buy a lower strike call, sell a higher strike call. Net debit strategy.
• Bull Put Spread — Buy a lower strike put, sell a higher strike put. Net credit strategy.

Bearish Vertical Spread (Bear Spread)

A bear spread is created when there is a bearish view on the market.

• Bear Call Spread — Sell a lower strike call, buy a higher strike call.
• Bear Put Spread — Sell a lower strike put, buy a higher strike put.

Horizontal Spread (Calendar Spread / Time Spread)

Horizontal spread involves options with the same strike price, same type, but different expiry dates. It is also known as a time spread or calendar spread. It is not possible to draw a payoff chart because the expiries underlying the spread are different.

Diagonal Spread

A diagonal spread involves a combination of options having the same underlying but different expiries as well as different strikes. These are the most complicated option spreads in nature and execution. Payoff charts cannot be drawn here either.

Straddle Long Straddle

Strategy: Buy a call and a put at the same strike price.

View: The market will move substantially in either direction, but the direction is unknown.

Max Loss = Sum of premiums paid for the call and put.

Profit arises when price movement in either direction exceeds the total premium paid.

Use case: Ahead of a major event (RBI policy, budget) where volatility is expected but direction is uncertain.

Short Straddle

Strategy: Sell a call and a put at the same strike price.

View: The price of the underlying will not move much or remain stable (low volatility expected).

Profit = Total premiums received (if the underlying stays near the strike price).

Strangle Long Strangle

Strategy: Buy a call and a put with different strike prices (both OTM).

View: The market will move substantially in either direction.

Similar to a long straddle but cheaper (lower upfront cost) because both options are OTM. However, the underlying must move more for the trade to profit.

Short Strangle

Strategy: Sell an OTM call and an OTM put with different strikes.

View: The market will remain stable over the life of the options.

Wider profit zone than short straddle but lower premium collected.

Covered Call

Strategy: Hold a long position in a bond (or bond portfolio) and sell (write) a call option on it.

Purpose: This strategy sells volatility in return for fees. It is used to generate extra income (premium) from existing holdings in bonds.

View: Mildly bullish. The fund manager does not expect a sharp rise in bond prices.

Risk: If bond prices rise sharply, gains are capped because the call will be exercised by the buyer.

Protective Put

Strategy: Hold a long bond portfolio and buy a put option on it.

Purpose: A fund manager anticipating a fall in bond prices can either sell his entire portfolio or short futures. Both of these exit the market. A protective put helps limit downside losses while keeping the upside, by paying a small option premium cost.

It works like insurance for the portfolio.

Butterfly Spread

A butterfly spread is an options strategy that combines both bull and bear spreads. These are neutral strategies that come with a fixed risk and capped profits and losses.

Long Call Butterfly

Strategy: Buy 1 lower strike call + Sell 2 middle strike calls + Buy 1 higher strike call.

View: Very low volatility in the price of the underlying is expected. The price will stay close to the middle strike at expiry.

Max profit: If the underlying price is exactly at the middle strike at expiry.

Max loss: Premium paid, occurring when price is below the lower strike or above the higher strike.

Summary: Option Strategy Quick Reference

Quick Recap for NISM IV Exam

• Three market participants: Hedgers, Speculators, Arbitrageurs.
• Hedge ratio formula: (Portfolio Modified Duration × Market Value) / (Futures Modified Duration × Futures Price / PAR).
• Vertical spreads — same expiry, different strikes.
• Horizontal spreads — same strike, different expiry (calendar spread).
• Long straddle and long strangle = high volatility expected; short straddle and short strangle = low volatility expected.
• Straddle = same strike; Strangle = different strikes.
• Covered call = income generation; Protective put = portfolio insurance.
• Butterfly spread = neutral, limited risk/reward.

Next Blog Post: Chapter 6 — Trading Mechanism in Exchange Traded Interest Rate Derivatives. We will cover the exchange trading system, order types, and trading members.

Practice these strategies with real exam questions. Visit passnism.in for the best NISM Series IV study material and mock tests.