Interest rate futures (IRFs) were first introduced as a concept in 2003 but it took another 6 years before it actually took off in 2009. The idea of interest rate futures is to hedge your interest rate risk which is the possible price loss caused by a rise in interest rates. However, this is one market segment that has not really taken off in India in a big way. For example, the currency derivatives that were introduced at the same time have seen very strong traction on the NSE and the BSE and commodities have also picked up. However, IRFs have left a lot to be desired. Let us first look at the concept of IRFs and its advantages before getting into why it has not taken off in India.
What are IRFs all about?
An Interest Rate Future is an agreement to buy or sell a debt instrument at a future date for a price fixed today. When you buy or sell an IRF, you buy or sell the bond in terms of a price fixed and not in terms of yields. You basically use the reverse approach; you buy the IRFs for a fall in interest rates and you sell the IRFs for an anticipated rise in interest rates. The underlying security for IRFs is usually a government bond or a treasury bill. Currently, the RBI has permitted trading of IRFs in Treasury Bills and in long dated 10-year benchmark bonds. Remember that IRFs have dual regulation by the RBI and SEBI. While RBI focuses on the interest rate impact of IRF trading, SEBI is more concerned about the securities market trading issues pertaining to IRFs.
What are IRFs used for?
Interest Rate Futures are primarily used to hedge or offset interest rate risks. Interest rate risk is the risk you are exposed to when you have an interest payable or receivable. If you are holding a fixed rate bond, then increase in rates becomes a risk because the bond prices will fall. When you are holding floating rate bonds, then fall in rates will mean lower yields and that becomes a risk for you. Basically, when you hedge, you take position in the futures market that is the opposite of that in the cash market. Like in most hedging activities, IRF has a cost in terms of hedging cost and the opportunity cost. The value of the contract goes up and comes down as market interest rates rise and fall.
Here is how an individual can practically use IRFs. If you have a floating rate home loan and expect the interest rate to go up in the coming 3 months it will mean that your borrowing cost will go up and so will your EMI. Are you prepared for that? You can offset this interest rate risk by selling interest rate futures contract. So if interest rates go up, the price of the contract for you falls and you make profits on the short IRFs. You can buy it back at a lower price and make profits. The advantage the IRFs enjoy vis-à-vis equity derivatives is that there is no securities transaction tax (STT). This makes it a lot more efficient.
Why have IRFs not taken off in India?
IRFs are still work in progress. There are a few reasons why they are yet to take off.
- Interest rate risk is still not so well understood risk in India as equity price risk, default risk and volatility risk. Most traders and investors still equate government bonds with absolute safety and hence don’t understand the concept of hedging their interest rate risk.
- The concept of hedging loan risks with IRFs is yet to take off in a big way in India. That is where the potential lies and that is what needs to be marketed as a business solution to the customers.
- Retail holding in government securities is still too limited and hence the need for retail investors to hedge risk is not seen today. That has limited the participation in this market substantially.
- Bond pricing in India is still not too efficient due to a restricted bond market and controlled interest rates. Till this issue is resolved and the yield curve develops, IRFs may face challenges for now!