Why a Notional Bond is being used as Underlying?
Currently, the underlying for bond futures in India is a notional 10 year government bond with a coupon payment of 7% p.a. Such a bond may not actually exist. So, let us understand why such a notional underlying has been selected. If futures were to be introduced on each of the government bonds, then there would be a large number of interest rate futures contracts trading on each bond and as a result, the liquidity would be poor for many of these futures. So a single bond futures has been identified which pays 7% p.a. as coupon rate and has maturity of 10 years. All bonds have been assigned a multiplier called conversion factor which brings that bond on par with the theoretical bond available for trading. We will learn more about the conversion factor in subsequent sections. If the bond future were to be based on an actual bond issue, it could potentially raise the activity in the futures market to such a large extent as to cause severe shortages of this actual bond for delivery at exp
