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Interest rate futures: The next big thing in derivatives trading

September 18, 2009 09:13 IST

Ever since the global financial crisis hit the economies world over, more and more regulators and markets across the world are seen drifting away from the over-the-counter forward market to embrace exchange-traded market.

The OTC market refers to transactions made outside the realm of formal and regulated exchanges. The main reason for this change, experts opine is that the centrally counter-party guaranteed exchange-traded market is perhaps the one institution to have come out unscathed in this economic meltdown.

In India, the trading in the newly launched derivates or more popularly the interest rate futures began on August 31, 2009 clocking trading volumes of Rs 276 crore in their first day of trade. A dream debut, indeed! But what is this index rate futures all about? Who is eligible and where can you trade them? Read on to find out the answers for these and much more about interest rate futures touted to be the next big thing in Indian derivates.

What is interest rate futures trading?

In a nutshell, an interest rate future is a financial derivative. For the uninitiated, a derivative is a financial contract the value of which is 'derived' from a long-standing security such as a stock or a bond, or even an asset, or a market index.

So an interest rate future is a financial derivate based on an underlying security, actually a debt obligation that moves in value as interest rates change. That is, buying an interest rate futures contract will allow the buyer to lock in a future investment rate.

When the interest rates scale up, the buyer will pay the seller of the futures contract an amount equal to the profit expected when investing at a higher rate against the rate mentioned in the futures contract. On the flip side when the interest rates go down, the seller will pay off the buyer for the poorer interest rate when the futures contract expires.

According to experts, the interest rate futures market had priced the futures so that there is sparse room for arbitrage.

Interest rate futures trade in India

In India, the underlying for interest rate futures trading is the Government of India's securitized 10-year notional coupon bond. The qualification of GoI securities to be used as underlying assets is that it should have a maturity status between seven-and-a-half years and 15 years from the first day of the delivery month.

This apart the outstanding should be for a minimum value of Rs 10,000 crore (Rs 100 billion). There will be a regular publishing of the list of deliverable-grade securities at the Exchanges.

Who can trade and where?

You are eligible to trade in interest rate futures market if you are a company, or a bank, or a foreign institutional investor, or a non-resident Indian or a retail investor.

You can trade live in interest rate futures on the currency derivatives segment of the National Stock Exchange while you could also soon trade the contracts on the Bombay Stock Exchange once it is launched. The foreign exchange derivatives bourse of the newly launched Multi-Commodity Exchange MCX-SX is awaiting the regulatory approval to commence trading in the segment.

The contract size and quotation

Globally, the interest rate futures are almost 25-30 per cent of all derivatives. In India the trading on the NSE will see a minimum contract size of Rs 200,000. As far as the quotation is concerned, it would be the same as the quoted price of GoI securities and with a count convention of 30/360-day.

The maximum tenor of contracts

While the maximum tenor of the futures contract is 1 year or 12 months, usually it will have to be rolled over in three months making the contract cycle span over four fixed quarterly contracts.

Daily settlement calculation and procedure for final settlement

Under normal circumstances, the weighted average price of the futures contract for the final 30 minutes would be taken as the daily settlement price.

However, at times when this trading is not carried out the exchange would fix the theoretical price as the daily settlement rate. Usually, the daily settlement is done on a daily marked-to-market procedural basis while the final settlement would be through physical delivery of securities.


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