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Deciphering interest rate futures

The credit crisis in the year 2008 has substantially increased the risk in global interest rate markets.

The credit crisis in the year 2008 has substantially increased the risk in global interest rate markets. With credit flows impeded due to lack of confidence in the world economy, volatility in interest rates has adversely affected market participants.

In India, interest rates have been highly volatile in the last 12 to 18 months. Increase in inflation during the first half of 2008 (crude oil touched a peak of USD 147 per barrel in July 2008) was accompanied by increase in interest rates. This impacted growth of the Indian economy. Subsequently, the correction in global commodity prices (from fourth quarter of 2008) resulted in lowering of interest rates to spur economic growth.

There is a growing need for mitigating interest rate risk using an effective and efficient mechanism. Banks, Primary Dealers, mutual funds, nsurance companies, corporates, financial institutions (FI), provident funds, foreign institutional investors (FII) and even individuals sourcing home loans or personal loans are exposed to volatility in interest rates.

In this perspective, the book, “A Guide to Interest Rate Futures” published by MCX Stock Exchange and Financial Technologies Knowledge Management Company Limited (FTKMC) is aimed at developing awareness and understanding of the concepts and contemporary market practice of using Exchange Traded Interest Rate Futures (ETIRF) for mitigating interest rate risk.

The book traces the evolution of interest rate markets from the Neolithic age and ancient civilizations when the concept of credit emerged in the form of lending and borrowing food or animals. This gradually developed towards implementation of systems for regulation of credit. The development of money markets and debt markets from the pre-independence era to the reform period after 1990 provides the reader with a firm foundation of financial markets.

The unique feature of this publication is that it not only analyzes the benefits and mechanics of trading in interest rate futures, but also highlights the regulatory aspects pertaining to the launch of Exchange Traded Interest Rate Futures as provided by the RBI-Sebi Standing Technical Committee Report (June 2009). The significance of the reforms in money markets and debt markets that has transformed the financial landscape of the Indian economy, benefits of interest rate futures as compared to the traditional OTC derivative products, product design, exchange risk management and the mechanics of trading in interest rate futures is explained with illustrative examples and case analysis. An overview of accounting and taxation issues for hedging using interest rate futures contracts is also included.

Over-the-counter (OTC) markets have inherent deficiencies related to credit risk (counterparty default risk) and liquidity risk. The large lot size of contracts in the OTC derivatives markets also prohibits the SME and MSME sector from hedging their exposure to interest rate and currency volatility. Need was felt for development of a simple and effective tool for mitigating risk. This gave rise to the concept of Exchange traded financial instruments, such as futures contracts.

ETIRF has significant benefits as compared to OTC derivatives. Introduction of ETRIF will add breadth to the markets and enlarge variety of products available to market participants for risk mitigation. This event is significant due to the non-availability of any liquid Exchange Traded derivative product to manage interest rate exposure in Indian financial markets.

The guide allows even a layman to understand the nuances of bond valuation and interest rate futures analytics. This initiative by MCX-SX and FTKMC will be of great relevance for all market participants in their effort to leverage on the benefits of ETIRF. The book is a single consolidated reference for any market participant who wants to know and understand the advent of interest rate markets and mechanism for mitigating associated risk. It is the first and only publication on ETIRF available in the market, even before the launch of interest rate futures under the latest guidelines issued by the regulators.

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First published on: 19-07-2009 at 23:48 IST
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