Interest Rate Futures

An Interest Rate Future is an agreement to buy or sell a debt instrument at a future date for a price fixed today.

The underlying security for IRFs is usually a government bond or a treasury bill. In India, National Stock Exchange and Bombay Stock Exchange offer trading in interest rate futures. You could use your Kotak Securities online account to avail the facility of trading through both exchanges.

Why Interest Rate Futures

• Interest Rate Futures are primarily used to hedge or offset interest rate risks.
• Hedging means taking a position in the futures market which is the opposite of that in the cash market. For example, if you bought a stock in the stock market, you sell a contract made of that stock in the futures market. That way you benefit if your bet is wrong and stock prices fall. Similarly, if you think interest rates on your loans are going to rise, selling a contract in the futures market would help you pay for the rising cost of borrowing.
• The value of the contract goes up and comes down as market interest rates rise and fall.

How does it work?

• Let us assume you have a housing loan. You expect the interest rate to go up in the coming 3 months.
• If interest rates go up, your borrowing cost will go up. This would mean Equated Monthly Instalment (EMIs) will rise accordingly.
• To hedge or offset this expected increase, you can sell an interest rate futures contract. So if interest rates go up, the price of the contract for you falls.
• You can then buy it at a lower price and deliver at a high price. This ensures that you recover the high borrowing cost of your home loan in the futures market.
• The minimum trade size is Rs. 2 lakh or 2000 bonds.

What are the benefits?

• It is a good hedging mechanism. In India, interest rates are high due to high inflation. However, at some stage, they could go down too. It may be a good idea to protect your borrowing costs against future movements in interest rates.
• There is no Securities Transaction Tax (STT). This makes hedging a reasonably efficient process.
• The real-time dissemination of prices means there is greater transparency in trading.