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What is an Interest Rate Future? Definition & How to Calculate

An interest rate future is a futures contract with an interest-paying underlying product. There is a contract between a buyer and a seller that governs the future delivery of an interest-bearing asset. With a futures contract, the buyer and seller can lock in the price of a future interest-bearing asset. This article explains the interest rate future in detail.

Interest Rate Futures Explained

There are two exchanges in India that offer interest rate futures – the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). You can open a demat and trading account and trade them. However, while opening a demat account, research properly and choose the best mobile trading app.

A government bond or T-Bill is the underlying security for these futures contracts. NSE trades standardised contracts based on Government of India Security (NBF II) and 91-day Government of India Treasury Bills (91DTB). In the interest rate futures market on the NSE, all futures contracts are settled in cash.

How Does Interest Rate Future Work?

The relationship between interest rates and bond prices is inverse. Bond prices tend to go down when interest rates go up, and bond prices tend to go up when interest rates go down.

Now, consider an investor who owns a bond and plans to sell it for a profit. The investor faces a risk if interest rates increase as the bond’s value decreases. This is because bond prices typically fall when interest rates rise.

An investor can mitigate this risk by using interest rate futures. Instead of facing potential losses from the declining value of the bond due to rising interest rates, the investor can sell these futures. Later, when the bond’s value has fallen, he can repurchase the futures at a lower price. This helps offset the decline in the bond’s value, allowing the investor to manage the impact of changing interest rates.

Who Can Use Interest Rate Futures?

The use of interest rate futures is limited for individuals due to the difficulty of matching the amount and tenure. Furthermore, it is crucial to understand how interest rates work and practice derivative trading.

If you have invested in tax-free bonds and expect interest rates to rise, the price of your tax-free bonds will fall. In such a case, you can sell the futures and repurchase them at a lower price to offset the loss.

Attributes of Interest Rate Futures

Now that we’ve explored interest rate futures, let’s look at some crucial elements.

1. In a security contract, the underlying asset is used to calculate the interest rate. An interest rate futures contract involves either a government bond or a T-Bill.
2. The contract’s settlement date is predetermined in the future.
3. In order to enter into a futures contract, a minimum deposit is required. As soon as you begin trading, your broker will require you to pay an initial margin. Brokers are required to submit this security deposit to the exchange.
4. A minimum investment of Rs 2 lakh or 2,000 bonds is required to trade these futures.

Let’s examine the benefits now:

1. A Suitable Hedging Mechanism

Futures serve as an effective hedging mechanism. Furthermore, they can be used for risk management. You can hedge your interest rate risk as a borrower by taking an opposite position in these futures.

1. No Security Transaction Tax

These futures do not have a security transaction tax, making them cost-effective.

Trading is more transparent since prices are available in real time.

Conclusion

A financial contract known as an interest rate future allows traders and investors to speculate on or protect against changes in interest rates. The underlying securities for these futures are government bonds or T-bills. In these agreements, a financial instrument is purchased or sold. For instance, treasury bonds may be purchased at a specified future date for a predetermined price. When the trader enters into an interest-rate futures contract, the prevailing interest rate determines the price. Accordingly, the price adjusts as the underlying interest rate fluctuates.

The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) offer interest rate futures in India. You can open a demat account with Share India to trade. The interest rate futures market provides traders with an effective way to manage interest rate risk. However, traders must understand how they work, their role in hedging, and the benefits and risks associated. This is essential to make informed investment decisions and improve their risk management strategies.

by naji
by naji

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