From the Ring: Decoding interest rate futures

What if I tell you that there is a financial product, being traded right now around the world, that is a derivative product (Futures and Options) but is not an equity or currency product and accrues 10 times the amount of turnover made on equity index futures? It is the most widely traded derivatives instrument in the world; and yet, it was only launched in India this year.

If you follow the markets, you probably know what I am talking about. For the uninitiated: it’s the Interest Rate Futures (IRFs).

IRFs were launched by all three major exchanges: the NSE, BSE, and MCX-SX around the third week of January 2014. On the first day, the turnover skyrocketed and ₹3,000 crore was clocked in by the NSE on January 21, on its inaugural day, while the BSE was able to clock ₹467 crore on January 28, on its inaugural day. In fact, during the first two weeks of trading on the NSE, it averaged close to ₹1,000 crore of turnover daily, while for the BSE this figure was ₹219 crore.

But, then, activity died down. Through October 30, the NSE has just maintained ₹1,000-crore worth of daily activity, while the BSE’s activity has, almost completely, shut down, averaging around ₹60-70 crore daily.

What are IRFs?

Interest rate futures (IFRs) are like any other futures derivative product: an agreement between the buyer and the seller for the future delivery of an interest bearing asset. Each country has different underlying assets, and India is no different: the underlying assets are 10-year Government of India bonds maturing in 2023.

When you trade IRFs, you are not trading the interest rate itself; instead, you are trading the future price of the bond. Bond prices move in different ways than, say, equities or currencies. Describing what bonds are and how/why they move is a topic on its own. Here, we will deliberate on the future of IRFs in India: are they here to stay?

A murky future

It’s unfortunate that IRFs did not pick up steam as the NSE, BSE and MCX-SX intended to; that being said, it’s unlikely that they are going to go anywhere. Interest rate futures are not just traded to earn profits; there is a legitimate reason for this. The IRFs are an excellent hedge against adverse movement of interest rates, and with the RBI possibly cutting rates and the US Federal Reserve being hawkish in its talks, this raises the volatility in interest rates and bond rates in future.

Bond prices are inversely correlated to interest rates; therefore, the IRFs are highly correlated with bond prices. This provides for excellent hedging opportunities. For example, assume a large MNC feels that short term interest rates are about to go down, it can hedge itself by buying IRFs. The positive attribute about the IRFs is that they are cash settled on expiration.

The IRFs were launched in the past but failed as they required physical delivery. They are also being traded by participants, including banks, traders, mutual funds, insurance firms, FIIs, corporate banks, and retail investors. But for the IRFs to really take-off, retail participation must increase. There is no way to really promote this unless there is a joint effort by brokers to promote the product. It is discouraging to see that while IRFs in the US clocked $1,285 trillion in turnover last year, India has only been able to record approximately $35 trillion in 2014 till date.

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