Interest rate futures trading is here – learn about it
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Gazing into the future may be a rewarding proposition but only a few enjoy the skills required to master the science. On Dalal Street, investors try to predict the market movement by trading in the derivatives segment. On August 31 this year, after a gap of six years, the National Stock Exchange (NSE) relaunched trading in interest rate futures (IRFs).
The reintroduction of this trading platform is not only anticipated to provide investors an opportunity to take a view on the interest rates and trade on them but also a chance to hedge the cash flow one may have due to their exposure to a housing loan or a long-term fixed deposit.
For the uninitiated, IRF is a contract to buy or sell a debt instrument (ten-year government bond bearing a notional interest rate of 7% payable half-yearly ) at a price fixed at the time of the contract for delivery at a future date. By locking into a price, the contract helps eliminate the interest rate risk. The transaction takes place via the stock exchange, which ensures delivery.
The underlying assets of an IRF contract usually are different interest bearing instruments such as treasury notes, treasury bills, treasury bonds, deposits and so on. In India, the underlying is a 10-year notional coupon bearing Government of India security. Analysts feel only if one has exposure to fixed income instruments, an individual should look at trading in this product and use it for hedging the risk.
This is because IRF, as an instrument class, is considered more complex than other financial products such as bonds or equity shares or mutual fund units. Globally, retail investors start with commodities, equity, currency, and then when they become savvy graduate to IRFs.
Debt experts say to gain an expertise in IRFs, inflation rate should be monitored closely. Next, your goal behind trading in this instrument must be clear as it can eventually help minimise risk and protect existing investments. “You should be well versed with the fundamentals of the product. So knowledge is the key.
Basics like historical range of interest rates and risks involved should be known before trading,” says Saurav Arora, senior vice-president , Jaypee Capital Services. Globally , IRFs is the most actively traded asset class with over 80% of entire derivatives volume coming from this product.This is how trading in IRFs occurs: if the interest rates are 8%, the IRF would be trading at 92, and if you expect the interest rates to increase to 9%, the future price would actually fall to 91 (100-9 ). Thus, the idea is if you are bullish on interest rates (anticipate a jump), you need to sell the IRF and vice-versa .
IRFs, like other futures contracts, have symmetric pay-offs (equal probability and extent of profit or losses) and is a leveraged instrument. So, on the one hand, if the interest rates move in favour of your anticipation, the pay-offs would be positive and return on investments high, depending upon the level of leverage. Then on the other, if the interest rates move against your expectations, the marked-to-market losses would be high and require you to honour margin requirements . “There’s a risk of extreme pay-offs .
To trade in IRFs, you need to have a subsidiary general ledger account with the exchange to facilitate delivery of securities at the time of settlement. As such there is no other criteria and any resident Indian can trade in IRFs in the same manner as one buys or sells equity in the futures and options market. National Stock Exchange, in fact, has waived off transaction fee till the end of this year. So, the only cost you would incur is brokerage paid to the broker.
“The contract size of the notional security is Rs 2,00,000 and with a margin of 2.5%, you can purchase a contract with funds of as low as Rs 4,500,” says Ramesh Kumar, head of debt markets & foreign exchange at Asit C Mehta Investment Intermediates.
With IRFs, debt experts feel one would have a better chance to make up for any depreciation loss if one anticipates a fall in bond prices. “You can go short to cover the loss. On the whole, it is a much more efficient platform to deal with market risk — either for speculative or risk control purpose,” says Arora. He, however, thinks the delivery mechanism is a little complex and could be improved to which Kumar of Asit C Mehta agrees. (Courtesy: Economic Times, India’s leading Business Daily)
