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Interest rates can highly influence one’s investment strategies. But predicting future interest movements is challenging. Here’s where interest rate futures come into the picture.
These standardised agreements come with an expiration date and unambiguous terms that help investors implement rate-driven investment strategies.
Today’s article will explore the fundamentals of interest rate futures. Stay tuned!
What is interest rate futures?
A futures contract with an interest-bearing asset is known as an interest-rate future. When a trader enters into a contract, they agree to the future delivery of an interest-paying asset.
Traders have the option to lock in the price of the interest-bearing instrument by investing in interest-rate futures contracts. They are based on assets like government bonds and Treasury Bills that pay interest.
The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) both provide interest rate futures in India. To trade in them, one can set up a demat account. We will discuss this in detail later.
How do interest rate futures work?
Traders may choose any asset that bears interest to take part in interest rate futures. The parties must exchange the interest-bearing asset at the end of the term of the futures contract or settle the contract in cash.
Cash is the most common method of settlement for futures contracts.
In cash-settled futures, value differences are settled daily instead of being aggregated at the expiration date, and the contracts are settled mark-to-market (a method of adjusting the value of an asset or liability to reflect its current market price or fair value).
Interest rate futures come in various forms and time frames, each tailored to a specific underlying instrument.
Take the example of a trader who owns bonds worth ₹1,000 per unit. The current interest rate is 8%. However, the trader expects the interest rate to go up to 10% soon. Hence, he fears that the increase can make his bond unattractive and lose its worth.
So, he enters into an interest rate futures contract with another trader to sell the bond at ₹1,200, irrespective of the interest rate fluctuation. This way, he hedges the risk of interest rate change.
You can buy back when the price of the futures contracts drops due to increased interest rates. One of the benefits of the difference in futures prices is that it helps you avoid the risk of interest rates going up. Another benefit is that they lower your EMI.
How can you trade interest rate futures in India?
Market participants on the NSE and BSE can purchase and sell these futures. To trade, you must work with a specified stock exchange member and fulfil some formalities to set up an account with a trading member.
You need to submit specific documents, such as a constituent agreement, a risk disclosure form, and a constituent risk declaration form. You will receive a client identification number after that. Also, you need to deposit the required money or collateral with the trading member before you start trading.
Features of interest rate futures
That said, let’s look at some essential parts of interest rate futures now:
Underlying asset:
The contract is based on the underlying asset, which is the security that pays interest. A government bond or T-Bill is used in interest rate futures contracts.
Date of expiration:
The expiration date is the last day that the predefined contract settlement can take place in the future.
Size:
By size we mean the total amount of the arrangement here.
Minimum required margin:
To begin a futures contract, you must deposit a certain amount. An initial or upfront margin payment to your broker is often necessary when you start trading. This acts as a security deposit that the broker must then give to the exchange.
Purpose of interest rate futures
Hedging and speculation are the most common use cases for interest rate futures. When it comes to futures contracts that are physically delivered, this might provide an investor with the opportunity to lock in (the time period within which the parties of a futures contract cannot terminate the contract without penalty) the interest-bearing asset.
They will get the security-bearing interest when the expiration date arrives.
Investors that have a long bond position may also employ interest rate futures. Bonds are the underlying assets of bond futures contracts, so when interest rates increase, the value of such contracts will likewise decrease. Bondholders have the option to sell interest-rate futures if they are concerned about an increase in interest rates reducing their wealth.
Interest rate futures are another way to see how the market reacts regarding rates.
Conclusion
In summary, interest rate futures are contracts that let you place bets on interest rate trends for hedging or profits. Understanding key aspects enables the strategic use of these tools to offset risks or capitalise on rate changes in your favour.
FAQs
No, you do not pay interest on futures contracts. You only pay an initial margin and a daily mark-to-market margin to maintain your position in the futures market.
Interest rate futures are futures contracts with underlying assets that provide interest, such as government bonds or Treasury Bills. These futures are traded on Indian stock exchanges like the NSE and the BSE, featuring standardised contracts based on government securities.
Interest rate futures are subject to market risk, liquidity risk, and operational risk. Market risk emerges from changes in interest rates. Liquidity risk comes from the possibility of low trading volume or wide bid-ask spreads, while operational risk arises from the possibility of errors, fraud, or system failures.
Futures trading might not be good for beginners, as it involves high leverage, volatility, and complexity. Futures trading requires a thorough understanding of the underlying asset, the futures contract specifications, the margin requirements, and the risk management strategies. Beginners may start with simpler and less risky instruments.
The futures price and the interest rate have an inverse relationship, meaning that when one goes up, the other goes down, and vice versa. This is because the futures price reflects the present value of the underlying asset, which is discounted by the interest rate.