Interest rate futures may sound complex, but they are invaluable tools for both seasoned investors and beginners looking to navigate the financial landscape. In this beginner-friendly guide, we’ll delve into what interest rate futures are, how they work, and their relevance in the Indian market.
What Are Interest Rate Futures?
Interest rate futures are financial derivatives designed to allow investors to bet on the future direction of interest rates or shield themselves from the risks associated with interest rate fluctuations. These futures contracts are rooted in underlying interest-bearing instruments, such as government bonds, treasury bills, or eurodollar deposits. Parties in an interest rate futures contract agree to exchange the interest earned or paid on the underlying instrument at a predetermined price and date in the future.
Utilizing Interest Rate Futures
Two Paths Interest rate futures serve dual purposes:
1. Speculation: Savvy investors use these futures to profit from their expectations of future interest rate movements. If an investor foresees an imminent rise in interest rates, they can “short” an interest rate futures contract, selling it initially and buying it back later at a lower price. Conversely, anticipating falling interest rates, they can “go long” on a contract, buying it and later selling it at a higher price for profit.
2. Hedging: Investors employ interest rate futures to protect existing or planned investments from the effects of interest rate changes. For instance, those with fixed-income portfolios paying a fixed interest rate can hedge against the risk of declining interest rates by purchasing an interest rate futures contract. This strategy offsets potential losses in their portfolio with gains from the futures contract should rates fall. Conversely, investors with variable income portfolios paying variable interest rates can hedge against rising rates by selling an interest rate futures contract, balancing gains in their portfolio against losses in the futures contract.
Where Are Interest Rate Futures Traded?
Interest rate futures are actively traded on centralized exchanges in India, such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). In the Indian context, the most popular interest rate futures are linked to government securities with varying maturities. These include 91-day treasury bills, 2-year treasury notes, 5-year treasury notes, 10-year treasury bonds, and 30-year treasury bonds. These contracts typically have a standard size of Rs. 2 lakh and are quoted in terms of yield (interest rate), rather than price. The relationship is inverse: when the price of an interest rate future rises, its yield falls, and vice versa.
Understanding with an Example
Imagine an investor who expects the yield of the 10-year T-bond to decrease from 6.75% to 6.50% in one month. On October 11, 2023, they decide to buy one contract of the 10-year T-bond futures at Rs. 90.21 per Rs. 100 face value. A month later, on November 11, 2023, the yield fell as expected, and the futures contract’s price rises to Rs. 91.08. The investor sells one contract at this price, resulting in a profit of Rs. 1,740.
Interest rate futures offer a valuable tool for investors to manage interest rate risk or capitalise on market movements. However, it’s essential to remember that they come with risks, including market volatility, liquidity concerns, and counterparty risk. Therefore, anyone considering trading these derivatives should thoroughly grasp their features, benefits, and potential drawbacks.
Interest rate futures open up a world of possibilities for investors, offering an avenue to navigate the complex world of interest rates with confidence. So, whether you’re looking to speculate or safeguard your investments, these futures could be a powerful addition to your financial toolkit.
Interest rate futures in India are financial contracts allowing investors to buy or sell a specific amount of an interest-bearing instrument, like government bonds or treasury bills, at a predetermined interest rate and future date.
Interest rate futures come in different types based on their underlying instruments, including Treasury bill futures, Treasury note futures (2-year, 5-year, or 10-year), and Treasury bond futures (10-year or 30-year). These futures have a standard size of Rs. 2 lakh and monthly expiry dates.
Yes, futures contracts consider interest rates. They are priced based on the prevailing spot price of the underlying asset and the anticipated future interest rate, also referred to as the cost of carry or risk-free rate.
Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.