Interest rate futures are a type of futures contract that are based on a financial instrument which pays interest. It is a contract between a buyer and a seller which agrees to buy and sell a debt instrument at a future date when the contract expires at a price that is determined today.
Some of these futures may require the delivery of specific types of bonds, mostly government bonds on the delivery date.
These futures may also be cash-settled in which case, the one who holds the long position receives and one who holds the short position pays. These futures are thus used to hedge against or offset interest rate risks. Which means investors and financial institutions cover their risks against future interest rate fluctuations with these.
These futures can be short or long term in nature. Short term futures invest in underlying securities that mature within a year. Long term futures have a maturity period of more than one year.
Pricing for these futures is derived by a simple formula: 100 – the implied interest rate. So a futures price of 96 means that the implied interest rate for the security is 4 percent.
Since these futures trade in government securities, the default risk is nil. The prices depend only on the interest rates.
Interest rate futures in India
Interest rate futures in India are offered by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). One can open a demat account and trade in them. Government Bond or T-Bills are the underlying securities for these futures contracts. Exchange Traded Interest Rate Futures on NSE are standardized contracts based on 6-year, 10-year and 13-year Government of India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). All futures contracts which are traded on NSE are cash-settled.
Features of interest rate futures
Now that we have had a look at what is interest rate futures, we will look at some key features.
- Underlying asset: The underlying asset is the interest-bearing security on which the contract is based. In case of an interest rate futures contract, it is either a Government bond or a T-Bill.
- Expiration date: This is the final date future for the settlement of the contract which is pre-determined.
- Size: This refers to the total amount of the contract. There is, however, a minimum requirement of Rs 2 lakh or 2,000 bonds if one wants to trade in these futures.
- Margin requirement: There is an initial amount required to enter into a futures contract. At the time of starting your trading, you will be required to pay an initial or upfront margin to your broker. This serves as a security deposit which the broker in turn has to submit to the exchange. For NSE, the minimum margin for a cash-settled interest rate futures contract is 1.5 percent of the contract’s value subject to a maximum of 2.8 percent on the first day of trading. For a 91-Days T-Bill futures contract the margin is 0.10 percent of the notional value of the futures contract on the first trading day. This becomes 0.05 of the notional value of futures contract after that.
How interest rate futures work
Since the interest rates and prices of bonds have an inverse relationship when interest rates rise, bond prices fall; the opposite happens when interest rates fall.
Let us say that an investor is holding a long position in a bond, so he expects to sell at a higher price. However, if interest rates rise, the value of the bond will fall, so rising interest rates are a risk for this investor. Since the bonds are an underlying asset in the contract, the bond prices will fall. Such investors can sell these futures so that they can repurchase them at a lower rate to counter the loss in the value of bonds he is holding.
Let us take an example. Let us assume that you have a home of a loan of Rs 50 lakh and you expect that due to RBI policies, the interest rates are going to go up in a certain period, let us say six months or one year. When interest rates go up, your EMI will also go up. To hedge the risk of rising EMIs when interest rates rise, you can sell an interest rate futures contract. If interest rates go up, the price of these future contract will fall, and you can repurchase them. The higher outgo in terms of EMI is offset to a certain extent by the difference in prices of futures and you are hedged against the risk of rising interest rates.
How to trade in interest rate futures in India
These futures can be bought and sold through trading members of NSE and BSE. You have to connect with a member of the given stock exchange with whom you would like to trade. To open an account with a trading member, you will need to complete certain formalities. This would include a constituent agreement, a constituent risk declaration form and a risk disclosure document. Once you submit the required documents and forms, you will be allotted a unique client identification number. To begin trading the necessary amount of cash or collateral needs to be deposited with the trading member.
Advantages of interest rate futures
Now let’s look through the benefits:
- A suitable hedging mechanism: These futures act as a good hedging mechanism. They are also a useful risk management tool. As a borrower, you can hedge your risk in fluctuating interest rates by taking an opposite position in these futures.
- No security transaction tax: There is no security transaction tax on these futures, making them a cost-effective option.
- Transparency in trading: Since there is real-time dissemination of prices, trading is more transparent.
Who can use interest rate futures?
The use of interest rate futures is limited for an individual because they may find it challenging to match the amount and tenure. It is also vital to understand how interest rates work and have a practice of derivative trading.
Finally, if you have invested in tax-free bonds and expect interest rates to go up, then the price of your tax-exempt bonds will fall. In such a situation you can sell these futures so that you can repurchase them at a lower rate and offset your loss.
Frequently Asked Question
How do interest rates affect futures?
Several factors affect the price of futures, including interest rates. To determine the present value of a futures contract that is a non-dividend paying non-storable asset, the trader will have to discount it by the risk-free rate.
In a risk-free rate situation with no existing arbitrage option, the price of the futures for a maturity period of T is following.
S0 = spot price
F0, T = The futures price of the underlying for a time horizon of T at period 0
R = Risk-free rate
How do you hedge interest rate futures?
Traders use two parallel transactions to hedge interest rate risks on futures, which involves,
- Borrowing at a market rate
- Determining the rates in such a way that profit or loss from the futures compensates for the interest risk
Traditional hedging techniques used to hedge interest rate on futures contract include,
- Matching and smoothing
- Asset and liability management
- Forward rate agreement
What happens to the price level when interest rates fall?
Historical trends show that price and commodity share an inverse relationship. When the interest rate rises, commodity prices fall, and the opposite happens when the interest rate falls.
For interest-rate futures India, the underlying asset is an interest rate carrying bond or stocks. Now, if the interest rate falls, the price of the futures contracts will go up. The trader can then repurchase the futures contracts to hedge from rising asset prices.
How do you trade interest rates in futures?
You can trade in interest rate futures in NSE and BSE. In the case of interest rate futures, the underlying asset is an interest-paying bond. So, when the interest rate rises, bond price falls, exposing the interest rate risk of the trader. To offset the loss arising from the rising interest rate, the trader will sell the futures contracts and buy the bonds at a lower price from the market.
What happens when interest rates rise?
The interest rate and price of a commodity are inversely related. So, when the interest rate rises, the value of the underlier falls. In the case of interest rate futures contracts, the price of the underlying stock, bond, or loan will drop. The trader will sell the futures to repurchase the underlier to avoid losses from rising interest rates.