Nov 4, 2014

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. In IRF, the underlying is an interest-bearing asset. The interest rate derivatives market is the largest derivatives market in the world. 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. Currently, Interest Rate Futures segment offers two instruments i.e. Futures on 10-Year Government of India Security and 91-day Government of India Treasury Bill.

- Bond Prices and how they move:

A Bond when issued for the first time by GOI, has a face value to it, which is basically the amount of money the issuer pays the holder of the Bond when the Bond matures. The face value of both the Bonds which are underlying in case of the IRF’s  (8.83% GOI 2023 and 8.40% GOI 2024)  is Rs.100.

Along with the face value, the other component is the coupon or interest amount that the holder of the Bond gets paid either annually or semi-annually. So, if you have invested Rs 100 at face value in an 8 % GOI Bond, maturing 10 years from now with a semi-annual coupon, you get Rs 4 (Rs 8/2, Rs 8 is 8% of Rs 100 invested) every 6 months for the next 10 years, and get back the Rs.100 on maturity after 10 years.

In summary, Bond prices are inversely related to interest rates in the economy, so:

--- If your view is that interest rates are going up, “Short” Interest rate futures (you profit because when interest rates go up, Bond prices come down).

--- If your view is that interest rates are going down, “Buy” Interest rate futures (you profit because when interest rates go down, Bond prices go up).

- 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
- the calculation of closing price on Zero coupon bond.
All of these shortcomings led the product to failure.  In December 2013, SEBI redesigned the product and had advised the exchanges to launch them after meeting the required constraints. IRF was thus again launched in January, 2014.

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