Options on Interest Rate Futures

03/09/2022 0 By indiafreenotes

An interest rate future is a futures contract with an underlying instrument that pays interest. The contract is an agreement between the buyer and seller for the future delivery of any interest-bearing asset.

The interest rate futures contract allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.

These futures may also be cash-settled in which case, the one who holds the long position receives and one who holds the short position pays. These futures are thus used to hedge against or offset interest rate risks. Which means investors and financial institutions cover their risks against future interest rate fluctuations with these.

These futures can be short or long term in nature. Short term futures invest in underlying securities that mature within a year. Long term futures have a maturity period of more than one year.

Pricing for these futures is derived by a simple formula: 100 – the implied interest rate. So a futures price of 96 means that the implied interest rate for the security is 4 percent.

Since these futures trade in government securities, the default risk is nil. The prices depend only on the interest rates.

Interest rate futures in India

Interest rate futures in India are offered by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). One can open a demat account and trade in them. Government Bond or T-Bills are the underlying securities for these futures contracts. Exchange Traded Interest Rate Futures on NSE are standardized contracts based on 6-year, 10-year and 13-year Government of India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). All futures contracts which are traded on NSE are cash-settled.

Features of interest rate futures

  • Expiration date: This is the final date future for the settlement of the contract which is pre-determined.
  • Underlying asset: The underlying asset is the interest-bearing security on which the contract is based. In case of an interest rate futures contract, it is either a Government bond or a T-Bill.
  • Size: This refers to the total amount of the contract. There is, however, a minimum requirement of Rs 2 lakh or 2,000 bonds if one wants to trade in these futures.
  • Margin requirement: There is an initial amount required to enter into a futures contract. At the time of starting your trading, you will be required to pay an initial or upfront margin to your broker. This serves as a security deposit which the broker in turn has to submit to the exchange. For NSE, the minimum margin for a cash-settled interest rate futures contract is 1.5 percent of the contract’s value subject to a maximum of 2.8 percent on the first day of trading. For a 91-Days T-Bill futures contract the margin is 0.10 percent of the notional value of the futures contract on the first trading day. This becomes 0.05 of the notional value of futures contract after that.

Advantages of interest rate futures

  • No security transaction tax: There is no security transaction tax on these futures, making them a cost-effective option.
  • A suitable hedging mechanism: These futures act as a good hedging mechanism. They are also a useful risk management tool. As a borrower, you can hedge your risk in fluctuating interest rates by taking an opposite position in these futures.
  • Transparency in trading: Since there is real-time dissemination of prices, trading is more transparent.