A Cash-Settled Derivative ,Where Physical Settlement Is Possible, Is A Non Derivative

by

V.K. Sharma

Former Executive Director

Reserve Bank of India

1.   In India, we have  a host  of exchange-traded cash-settled derivatives contracts like currency futures and options , Govt bond ( Interest Rate ) futures and single stock futures and options which  all settle in cash rather than by physical delivery on their expiration .  In contrast , in the US , these very same derivatives contracts are required to be settled by physical delivery on their expiration  . And the reason why derivatives , where physical settlement is possible, must settle not in cash , but by physical delivery, on expiration of the contract is that this discipline ensures almost real-time "organic connect" , coupling ,alignment and lockstep convergence between derivatives price and the underlying cash market asset price much like the " organic connect " of umbilical cord between the foetus and the mother until physical delivery .

2.  Significantly, regardless of whether derivatives are over-the-counter (OTC),  or exchange-traded,  the underlying  theory and practice has been the so-called "law of one price" or, what is the  same thing as ,the " no-arbitrage argument", involving replication of derivatives cash flows in the underlying cash markets.  In other words, a derivative of an underlying cash market asset which derives its value from that of the underlying cash market asset, will be so priced/valued that it is not possible to arbitrage between the cash market price  and the derivative price because the derivative is correctly priced relative to the underlying asset in the cash market. For, if a derivative were priced expensive relative to the underlying asset in the cash market , an arbitrageur will engage in risk less arbitrage by selling the expensively priced derivative and simultaneously buying the asset in the cash market by financing it at the going lower ( than the repo rate implied by the expensively priced derivative contract ) repo rate and physically delivering  the asset on expiration and thus realizing the risk free arbitrage profit ! In the opposite case, where the derivative is priced cheap relative to the underlying asset , an arbitrageur will engage in risk less arbitrage by shorting the asset in the cash market, investing the proceeds of short sale at the higher actual repo rate and buying the relatively cheap derivative ( lower implied repo rate) and taking physical delivery of the asset on expiration of the contract and thus again earning risk free arbitrage profit ! This seamless and frictionless risk free arbitrage, made possible by the discipline of physical settlement on expiration, will continue apace until, in equilibrium, the derivative was correctly priced/valued relative to the underlying asset in the cash market , " so much so that this very near perfect arbitrage-free pricing of derivatives itself will result in negligible actual physical delivery on expiration with participants closing out their open derivatives positions with offsetting trades before expiration !" In a physically-settled derivative contract , the only open positions that go into actual delivery at expiration are only the arbitrage positions and not even those of hedgers who close out their positions just before expiration  ! Anecdotal evidence from derivatives exchanges around the world is that in the physically-settled derivatives contracts , actual delivery is almost absent if not exactly zero ! And it is precisely this feature of a physically- settled derivative contract of almost "no actual delivery " on expiration ,due to the discipline of cash-derivative arbitrage, that is the incontrovertible touchstone and hallmark of an efficient, deep and liquid derivatives market which fully delivers on its public policy purpose of real time efficient lockstep price discovery and basis-risk-free hedging in the underlying cash market assets ! So , paradoxically, in the case of physically-settled derivatives , actual physical delivery on expiration "doesn't happen precisely  because it can happen" were the prices of the derivatives and the underlying assets in the cash market to diverge, decouple and disconnect and not move in lockstep  !

3. But in the case of cash-settled derivatives contracts, where physical settlement is possible, because of the absence of risk free cash-derivatives arbitrage and the leverage typical of derivatives , there is considerable scope for a derivative to derive its  price from itself , rather from its underlying asset in the cash market, and for speculators to make derivative price go way too out of sync and  lockstep alignment with those of the underlying asset , which , in turn, has the effect of making the derivative a " non-derivative ", exposing hedgers to not inconsiderable "basis-risk" , and defeating , in the process, the very public policy purpose of a derivative acting as an effective true hedge  !

4.  The foregoing cannot happen in the physical settlement version because , if a speculator manipulates the derivative price to be higher relative to that of the underlying , he will be punished by arbitrageurs who will buy the underlying asset cheap in the cash market and deliver it to the price manipulator at his higher price , making , as we have seen above, a risk free arbitrage profit entirely at the expense of the manipulator ! In the opposite case , risk free arbitrageurs will punish the manipulator by making him deliver an otherwise expensive asset at a lower derivatives price , again , as we have seen above, earning a risk free arbitrage profit entirely at the expense of the manipulator !

5.  Significantly, and interestingly, such seamless and frictionless arbitrage also applies, just as much, to derivatives themselves !  Illustratively, a long position in a forward/ futures can also be replicated by buying a call option and selling a put option with the strike prices for both at the current forward/ futures price.  If the actual forward/futures  price is expensive relative to the ‘synthetic’ forward/futures (call + put options), an arbitrageur will engage in risk-less arbitrage by selling the expensively priced forward/futures  and buying the relatively cheap ‘synthetic’ forward/futures (call + put options) and vice versa !

6.  While the underlying assets in the case of single stock futures/options and currency futures / options are homogeneous , this is not the case with Government bonds underlying the Interest Rate Futures. This is because a standard 10 year Government bond futures contract will cover a deliverable basket of comparable maturity bonds with widely differing coupons. They are made comparable through what is known as conversion factor which is unique to each deliverable bond . To arrive at the conversion factors of individual deliverable bonds , they are all priced to give the yield of the notional/ hypothetical par bond underlying the IRF . These prices are then divided by the par price to give respective conversion factors .

7.     It will be instructive to review the evolution of the physically-settled IRF since its launch in August 2009. After their second launch in August 2009, Interest Rate Futures on 10-year notional government bond had seen two settlements, viz. the December 2009 contract and March 2010 contract.  Significantly, both traded volumes and Open Interest (OI), witnessed decline over the two settlements, eventually decaying very quickly to zero permanently.  In particular, the December 2009 contract, which had a peak Open Interest of Rs. 980 million declined to a pre-settlement Open Interest of Rs. 610 million and settled “entirely” by physical delivery, representing physical settlement of 62% of the peak Open Interest.  In contrast, the March 2010 contract, which witnessed a peak Open Interest of Rs. 570 million declined to a pre-settlement Open Interest of Rs. 420 million and also settled entirely by physical delivery, representing physical settlement of 72% !  Both these settlements were a far cry from the hall-mark and touch-stone of an efficient, frictionless, seamlessly coupled, and organically connected, physically-settled futures market even where physical delivery  typically  does not exceed 1%  of the peak Open Interest !  In fact, on Chicago Mercantile Exchange and New York Mercantile Exchange, settlement by physical delivery is as low as 0.4% even though the contracts are physically settled types . This happened because of the inefficient ‘disconnect’ and ‘friction’ in the IRF market due to only one way arbitrage viz. buying the cheapest-to-deliver (CTD), with the highest implied repo rate (IRR), by financing the same at the lower actual repo rate and simultaneously selling futures.  In fact, as ascertained from one market participant, who accounted for almost the entire Rs. 600 million worth of physical delivery into the December 2009 contract, the implied repo rate of the CTD was 6.75% as against the actual repo rate of 3.4%,  representing  a risk-free arbitrage profit of 3.35% !!  But unlike this, on the other side, for the so-called benchmark, and most expensive-to-deliver, Government bond , the IRR was almost zero to negative, suggesting an arbitrage opportunity of short-selling this bond and investing the proceeds of short sale at much higher actual repo rate and buying the futures contract !  " But ,alas, this arbitrage could not be engaged in for want of short selling for a period co-terminus with that of the futures contract. "  It is the possibility of this two-way arbitrage, working in the opposite directions, that, like a “good conductor” of ‘heat’ and ‘electricity’ in physics, will seamlessly conduct/transmit/permeate/impart liquidity and homogeneity, as it were, from the relatively more liquid (the most-expensive-to-deliver) benchmark government bond to the so-called illiquid (the cheapest-to-deliver) and heterogeneous bonds in the deliverable basket !

8.   As we can easily see above , the physically-settled IRF failed not because of any design defect but because of the absence of the necessary and sufficient conditions for efficient , seamless and frictionless cash -derivatives arbitrage between the deliverable bonds and the futures contract . So , it might just as well be to list out the necessary and sufficient conditions for physically-settled IRF to succeed as indeed it has in all the developed and mature markets across the world. And the necessary and sufficient conditions are as under :

i)   Symmetrical and uniform accounting treatment of both cash and derivatives markets.

ii).  Removal of the ‘hedge effectiveness’ criterion of 80% to 125% which militates against use of derivatives for hedging purposes for it is better to have ‘ineffective’ hedge than to have no hedge at all !

iii)  .  Roll-back of the Held to Maturity (HTM) protection i.e. substituting the current “accounting hedge” with “derivative hedge”.  This is because with HTM, there is no incentive/compulsion whatsoever for use of market-based solutions like IRF which also require constant monitoring, infrastructure, transaction costs like brokerage and margins etc.  

iv).  Delivery-based short-selling in the cash market for a term co-terminus with that of the futures contract and introduction of term repo, and reverse repo, markets, co-terminus again with the tenure of futures contract for borrowing and lending of cash and G-Secs.

Both for IRS and IRF, actual notional/nominal amount of IRS/IRF must be allowed on duration-weighted basis unlike the current regulation which restricts the maximum notional/nominal amount of hedging instrument to no more than the notional/principal amount of the exposure being hedged resulting in under-hedging of risk .

9. But rather than establish and continuously ensure the above necessary and sufficient conditions on the ground for asuccessful physically-settled IRF , a cash-settled  IRF on government bond was launched , instead , which will , to all intents and purposes, exist and trade as “ an end in itself” , rather than “ as a means” to the larger public policy purpose of real time efficient lockstep price discovery , liquidity, depthand basis-risk free hedging in the stock of the heterogeneous government bonds .