When we speak of trading in futures, most market participants are well-versed with the concepts of equity index futures or commodity futures. Few consider actively tracking interest rates and their movements in order to make profitable trading or investing decisions. Most investors would rather only monitor interest rate movements for their loan EMIs or debt mutual fund portfolios.
In India, trading in interest rate futures began in August, 2009 with a trading volume of Rs 276 crores just on its first day. Most banks, financial institutions and other treasuries invest in debt instruments like T-Bills, corporate bonds and high-yield bonds. They trade in interest rate futures to hedge themselves against changing future interest rate movements.
But what are interest rate futures?
Interest rate futures, like equity or commodity futures, are contracts to buy or sell a debt instrument (which may be a T-Bill or government security) at a future date for a price fixed today. The underlying security for an interest rate futures contract is usually a 10-year government security. They are traded on both the NSE and the BSE.
Banks, financial institutions, foreign institutional investors as well as retail investors can invest in interest rate futures.
We know that interest rates and the prices of bonds are inversely related, which means, that when interest rates rise, bond prices fall and when interest rates fall, prices of bonds rise. Thus, traders who anticipate the rise in interest rates in the future would tend to sell an interest rate futures contract so as to profit from the drop in price on the settlement day.
In India however interest rate futures are seldom used to make profits. Instead, they are largely used to hedge current debt investments and protect them from the risks of changing interest rates.
How to trade interest rate futures?
Let us assume you have a housing loan and you expect that the RBI Policy is likely to raise the repo rate and reverse repo rates in the coming 6 months, thereby signalling an increase in your loan rates by the bank.
In order to offset the impact of rising EMI burden when rates rise, you can sell an interest rate futures contract. If the rates actually go up over the next 6 months, the price of these futures contracts will fall and you can then buy them back again.
This will ensure that the higher outgo in the form of higher EMIs gets compensated to some extent by the difference in the futures price, thereby helping you hedge yourself.
There is however, a minimum size of Rs 2 lakhs or 2000 bonds in order to trade in interest rate futures markets.
Thus, interest rate futures help you offset potential losses from variations in the interest rate environment driven by various policy changes presenting a good hedging mechanism. The process is also relatively efficient with real-time information dissemination of prices of the futures contract.