Capital Market

NSE launched trading in Interest Rate Futures (IRF) on 31st August 2009. Let us understand whether Interest Rate Futures are only for corporates and financial institutions or can retail investors too benefit. The bond markets have been active for some time now with good participation by insurance companies and other financial institutions. But the retail investors who are exposed to interest rate fluctuations did not have an instrument to hedge this risk till now. Earlier, investors who had taken loans had to either pay the increased interest or switch the loan from a high interest charging bank to a lower interest charging bank.

The re-introduction of IRF will help both retail investors and corporates. The major beneficiaries of Interest Rate Futures are:-

Banks: Banks being lenders and borrowers have to contain their risk especially at times when there is high fluctuation in interest rates. They can manage the duration gap with respect to change in interest rates, hedge against re-pricing risk related to volatility of cash flows due to revaluation of assets and liabilities over a period of time, and mitigate risk when yield on assets and costs on liabilities are based on different benchmarks. E.g. a banker expects a disbursement of Rs 50 lakhs in the next 3 months. The prevailing interest rate is 8.5% and he expects the rates to come down to 7.5% affecting the income from such a disbursal. In such a situation what can the banker do? The banker can buy Interest Rate Futures worth Rs 5000000 (5000000/200000) i.e. 25 lots. When the interest rates come down, the IRF prices move up offsetting the loss arising out of the falling interest rates. Retail lenders can also hedge their interest rates in the IRF market.

Portfolio Manager: A portfolio manager expects to receive Rs 10 lakhs in the next three months, the present interest rate being 8.5%. In the next three months time he expects the interest rates to fall towards 7.5% due to macro economic reasons. In order to safeguard his portfolio he can buy IRF worth
Rs 10 lakh (1000000/200000) i.e. 5 lots. In time, the interest rates fell as expected pushing the IRF prices up. The portfolio manager may have incurred a loss from a fall in interest rates but at the same time he made a profit from his investment in IRF. The profit from purchase of IRF offset the loss from rise in interest rates.

Retail investors who have availed loans: The small lot size provides retail investors the opportunity to hedge their interest rate payment on home loans to get protection against rising interest rates. E.g. a person who has taken a home loan of Rs 30 lakh on a floating interest rate of 8.5% expects the rates to go up towards 9.5% in the next 3 months incurring a larger interest amount in his repayment. To protect himself, he can sell IRF worth Rs 30 lakh i.e. 15 lots. If the interest rates rise as anticipated towards 9.5%, the IRF will come down and so selling IRF will give him profit and offset the loss due to rise in interest rate on his home loan.

Retail Investors who have exposure in Equities and Bonds: When there is an interest rate high, equity and bond prices will fall because investors will sell equities and invest in riskless assets. Hence, if there is a hike or a expectation of an interest rate hike, investors can take short positions in Interest Rate Futures.

A retail investor should be aware of the factors that can affect interest rates thereby causing ups and downs in IRF. Some of these factors are-

Inflation: Rise in inflation forces the government to increase the interest rates and vice-versa. Rising interest rates would affect bond prices adversely, pushing IRF prices also down.

Financial Policies by Ministry: Financial policies by the Ministry of Finance would have some effect on the prevailing interest rates which would consequently affect the IRF market.

RBI Meetings and Policies: The RBI meetings and policies may or may not bring changes in benchmark interest rates. But speculation on reduction and increasing of interest rates would bring about activity in the bond market and IRF market. E.g. a hike or reduction in CRR, Repo and Reverse Repo rates.

Rupee Fluctuation: If the currency of a country is weak (in comparison with other currencies) then the Central Bank may increase the interest rates to boost currency values and vice-versa.

Interest rates of other countries: If there is widespread parity in interest rates between countries then the Central Bank will intervene.

Thus, Interest Rate Futures can be a very good instrument or tool for retail investors as well to hedge their positions against interest fluctuations.