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| What exactly is interest rate futures?
By Tanvi Varma
The liquidity crisis during the recent economic slowdown was a nightmare that the mutual fund industry won't forget in a hurry. As investors scrambled to withdraw money, many debt funds either found no buyers in the market or had to sell their underlying bonds at throwaway prices. Hopefully, the situation won't repeat itself soon, but if it does, mutual funds have a new weapon in their armoury to fight such a freeze: interest rate futures, popularly known as IRFs.
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"With interest rate futures, at least you have another option instead of selling your bonds when there are no takers, you can hedge your position by selling the same in the futures market, says Shobit Gupta, head, fixed income, Principal PNB AMC.
What exactly is an IRF? Like any other derivative product linked to an underlying asset, IRF is a contract to buy or sell a debt instrument currently a 10-year government bond bearing a notional interest rate of 7% payable halfyearly, at a price decided in advance for delivery at a future date. IRFs were recently launched on the National Stock Exchange with a minimum tradeable lot size of Rs 2 lakh. Previously launched in 2003, the IRF did not perform satisfactorily primarily due to two reasons: product design and the fact that banks could only hedge it on their investment portfolio and couldn't take a trading position, according to Shyamala Gopinath, deputy governor, Reserve Bank of India.
Not just funds, interest rate risk affects savers and borrowers too. For instance, while taking a home loan you face the risk of the rates moving up. When you invest, the fear is that the interest earned could go down. As a borrower, if you foresee a rise in interest rates, you can go short in the market, that is, sell futures.
However, this is a complex instrument and you may never be able to get a perfect hedge, says Gupta. This is because the futures price is related to a 10-year government bond, whereas your loan is related to the bank's prime lending rate. If the RBI cuts interest rates by 4%, banks may cut their PLR by only 2%, so the movement in the futures price may not be in sync with the movement in your loan rate.
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