The Complete Guide to Interest Rate Futures

Key Highlights

• Interest rate futures involve 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 National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), featuring standardised contracts based on government securities.

• Traders generally use interest rate futures to hedge against potential increases in interest rates, providing a mechanism to offset rising borrowing costs.

Interest Rate Futures Meaning

Interest rate futures are futures contracts that carry underlying assets which offer interests. Interest rate futures are available in India (BSE) on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Government bonds or Treasury Bills are the underlying instruments for these futures contracts.

Standardised contracts based on 91-day Government of India Treasury Bills (91DTB) and six, ten, and thirteen-year Government of India Security (NBF II) are traded on the NSE. Cash settlement is available for all these interest rate futures contracts.

How do Interest Rate Futures Work?

Now that you know the interest rate futures definition, let's see how they work.

• Let us assume you have a housing loan. You expect the interest rate to go up in the coming three months.

• If interest rates go up, your borrowing cost will go up. This would mean equated monthly installments (EMIs) will rise accordingly.

• You can sell an interest-rate futures contract to hedge or offset this expected increase. 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 it at a higher 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.

Interest Rate Futures Example

Let's consider an example to understand how interest rate futures work. Assume that you have a Rs 35 lakh house loan. You anticipate an increase in interest rates due to the Reserve Bank of India’s (RBI) policy within six months or a year. Your EMI increases along with an increase in interest rates. You might sell an interest-rate futures contract to reduce the risk of increasing EMIs when interest rates rise.

You can repurchase these futures contracts if interest rates rise, as their value would decline. The difference in futures prices partially offsets the greater EMI expenditure. So, you can safeguard yourself against the risk of rising interest rates.

Characteristics of Interest Rate Futures

Here are some important characteristics of interest rate futures.

• The contract specifies the deadline (date) for its settlement.

• A minimum investment of Rs 2 lakh, or 2,000 bonds, is required to trade these futures. You must pay your broker an initial margin to start trading. This acts as a security deposit. The broker shall deposit it to the exchange.

• On the first trading day, the minimum margin for cash-settled interest rate futures traded on the NSE is 1.5%. The maximum amount is up to 2.8%.

• On the first trading day, the margin for a 91-day T-Bill futures contract is 0.10% of the contract's value.

• From the second day, the charges are 0.05% of a futures contract's notional value.

Benefits of Interest Rate Futures

The following are the benefits of investing in interest-rate futures.

• 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. Protecting your borrowing costs against potential interest rate changes in the future can be a smart strategy.

• There is no Securities Transaction Tax (STT). Due to this, hedging becomes quite cost-effective.

• The real-time information on prices ensures greater transparency in trading.

Conclusion

A futures contract with an underlying financial asset that pays interest is an interest rate futures. Traders mostly use it as a hedge against unfavourable fluctuations in interest rates. They are very crucial instruments for reducing the interest rate risk. So, interest rate futures help safeguard portfolios from the effect of market swings.

However, there are some risks also. These include the changes in interest rates and prevailing market conditions. So, investors must research thoroughly about each contract and check its terms and conditions. Moreover, they may also seek advice from experienced market experts to make the right trading choices.