The Working of Interest Rate Future Contract
Investment in the future contract is exciting and risky. There are various types of futures contracts such as individual stock futures, stock indexed futures, commodity futures, currency futures, and Interest rate futures. An individual stock future contract mainly deals with a stock, whereas a stock index future contract deals with a stock index. A commodity future deals with commodity prices and currency futures with currencies. But an interest rate future is a type of futures contract which is mainly based on a financial instrument that pays interest. It is mainly a contract between a buyer and a seller that agrees to buy and sell a debt instrument at a future date. The price of the contract is determined today. It is the most widely traded derivatives in the world. But in India, it is still at an early stage. In India, interest rate futures contracts are based on Government bonds or T-Bills as underlying securities. Interest rate futures contracts behave like Bonds. The prices of interest rates futures contracts are inversely related to actual interest rates prevailing in the economy. In case, if the interest rates are increased then the bond prices will fall and when the interest rate is decreased then the bond prices will go up.
- If anyone expects the RBI to reduce the interest rate in the future, then he/she needs to go long in interest rate futures.
- If anyone expects the RBI to increase the interest rate in the future, then he/she needs to short interest rate futures.
Working of Interest rate future:
Let’s try to understand the interest rate future with a home loan. Assume that a person has taken a home loan. He/she expects the interest rate to go up in the coming 4 months. In case, if the interest goes up, so does his/her equated monthly installment will rise. To hedge against the expected increase, he/she can sell an interest rate futures contract. If the interest rates go up, then the price of the contract will fall. Then they can buy it at a lower price and deliver at a higher price. It ensures that he/she recovers the high borrowing cost for their home loan in the future market.
In India, Both NSE and BSE have their respective interest rate futures contracts. All future contracts available for trading on NSE are cash-settled. Now the current exchange-traded interest rate futures on NSE are:
- Mainly a standardized contract based on 6 years, 10 years and 13 years Government of India security. (NBF II )
- 91 day Government of India Treasury bill (91 DTB ) based on standardized contract
In India however, interest rate futures are hardly used to make a profit. They are mainly used to hedge against current debt investment and protect them from the risk of changing interest rate risk. There are certain specific components of interest rate futures which must be taken into notice before buying it :
- Underlying Asset: It is mainly the interest-based security on which the contract is based upon.
- Size of the contract: It is mainly the total amount of contract. In India, the minimum contract is of 2000 bonds in case one wants to trade in the future.
- Expiration Date: It is a pre-determined date at which the contract will be settled either through physical delivery or through cash.
- Margin Requirement: To enter a futures contract, there is an initial amount required to pay as an upfront margin to your broker. It is called a margin requirement, which acts as a security deposit, which the broker, in turn, must submit to the exchange.
It provides us the opportunity to take high leverage at such a small amount. Apart from it, let’s look at the different types of advantages in trading in futures:
- Perfect hedge: A future contract acts as a perfect hedge against any kind of financial risk. It is a perfect risk management model for carrying out other risks in any other financial instrument.
- No security taxation: There is no security taxation on these trades in the future, hence making them a cost-effective option.
Total transparency: Manipulation in price is one of the tools in the financial market to boost profit. But in the case of interest rate futures, there is total transparency as the rates are fixed upon the central bank depending upon economic outlook.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing