Interest Rate Futures - Overview
Basics of Interest Rate Futures and Its Story in India
Interest Rate Future (IRF) has been in news recently because of some structural changes happening in the product from the regulators. SEBI has taken a lot of effort to make sure the product picks-off well compared to its earlier version. So, today we will dwell on some basics of IRF and try to understand how the recent changes will help in creating more liquidity for the product in India.
What are Interest Rate Futures?
Just like any other Future instrument, an interest rate future is a financial derivative product. The way equity future price is based on stock price of that equity, an IRF price is also based on some underlying. But the interesting part here is the underlying. In IRF the underlying is an interest-bearing asset. Now that may sound alien in India. Never heard about any such assets? Actually, we all deal with them in some way or the other regularly. As an individual, when you take any sort of loan (be it housing loan or educational loan or investing your money in some Government or company fixed deposit), you are part of such interest bearing instruments. As a corporate whenever you raise money from the market by issuing bonds you are linked to these interest bearing instruments. Even institutions like Banks, Insurances etc have their portfolio invested in a money market which are impacted by these interest rate changes.
Why do we need Interest Rate Futures?
A very important question that pops up in our heads is why we do need a product like IRF. My one line answer would be to secure your future risk arising due to volatility in the Interest rate. In simple language, any changes happening in interest rate is going to affect all the above mentioned participants in one way or another.
You must be wondering how changes in interest rate can affect you. Let’s take a simple example; suppose you need to buy a home and you take a loan from the bank. The bank charges you a floating rate of interest say 10%. After a year of taking the loan, the interest rate increases to 11% due to economic activity. This increase in interest rate increases your EMI payment to the bank and thus reduces your savings. If not planned properly the costs can continue to rise.
In another example suppose you are a director of a public company that issues bonds in the market for financing projects and your company issues the bond at 11% (this is the cost of capital of your funds). Now if the market interest rates drop to 10%, you still need to pay the lenders rate finalized at 11%. This in itself is a losing proposition and ends up costing your company money.
In both examples, IRFs can be used to secure against the movement of interest rates. Just like other future instruments it can be used for hedging, arbitrage and speculation.
Relation between Interest Rates and IRF
There exist an inverse relation between Interest Rate and Interest Rate Futures. That is, when interest rates rise, the prices of Interest Rate Futures will fall (as the value of the underlying IRF will decrease) and when the interest rates are set to fall the IRF increases. Remember this relation when trading IRFs. If your view about interest rates are that they may rise in the future, you should short interest rate futures, and if you believe interest rates are going to go down you should go long on interest rate futures.
h2Uses of Interest Rate Futures
Interest rate futures are used to hedge against the risk of that interest rates will move in an adverse direction, which may cause a loss.
For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship between interest rates and bond prices to hedge against the risk of rising interest rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a profit can be made when closing out of the future (i.e. buying the future).
It's important to note that interest rate futures are not directly correlated with the market interest rates. When one enters into an interest rate futures contract (like a bond future), the trader has ability to eventually take delivery of the underlying asset. In the case of notes and bonds this means the trader could potentially take delivery of a bunch of bonds if the contract is not cash settled. The bonds which the seller can deliver vary depending on the futures contract. The seller can choose to deliver a variety of bonds to the buyer that fit the definitions laid out in the contract. The futures contract price takes this into account, therefore prices have less to do with current market interest rates, and more to do with what existing bonds in the market are cheapest to deliver to the buyer
Interest Rate Futures in India
IRF has been launched twice in India, first in the year 2003 and then in 2009. Both versions had few drawbacks like physical settlement of contracts, short term underlying and the calculation of closing price on Zero coupon bond. All of these shortcomings led the product to failure. Recently in December 2013, SEBI redesigned the product and have advised the exchanges to launch them after meeting the required constraints.
The central bank has permitted exchanges to offer both physical and cash settled IRFs on the notional 10-year government securities. The physically settled 10-year IRF would have a semi-annual coupon rate of 7 percent. The cash-settled 10-year derivative would be based on either a 10-year government bond with residual maturity between 9 and 10 years, or a basket of 10-year bonds that have residual maturity of between 9 to 11 years. All future IRF contracts will be based on the 91-day treasury bills, 2-year and 5-year coupon bearing government securities and other coupon bearing securities will be eligible to be cash-settled based on certain conditions.
More details for IRF can be found at:
Lets hope that this version of IRF kicks off well so we can participate! RKSV will surely make the it available for our clients to trade when it is available. IRF and Bonds can be a part of everyone's portfolio. These products are very much important from an asset allocation point of view too which determines the success of investors overall portfolio return. So let's trade and participate in the growth of the Indian bond market and make it really vibrant.