What are Interest Rate Futures?

An interest rate future means the futures contract with an interest-paying underlying product. A contract is an agreement between a buyer and a seller for the delivery of an interest-bearing asset in the future.

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

Interest Rate Futures Explained

The two exchanges - the National Stock Exchange (NSE) and the Bombay Stock Exchange - both offer interest rate futures in India (BSE). A Demat account can be opened and traded in. 

The underlying securities for these futures contracts are government bonds or T-Bills. On the NSE, standardized contracts based on 6-year, 10-year, and 13-year Government of India Security (NBF II) and 91-day Government of India Treasury Bills are traded (91DTB). All futures contracts sold on the interest rate futures NSE are settled in cash.

How Does it Work?

As the interest rates and bond prices are inversely related, when interest rates rise, bond prices fall, and vice versa when interest rates fall.

Let's assume an investor has a long position in a bond and anticipates selling it at a higher price. Rising interest rates, on the other hand, will lower the bond's value. Hence rising interest rates constitute a danger for this investor. Bond prices will fall because bonds are an underlying asset in the contract. Such investors can sell these futures and repurchase them at a lower price to compensate for the decline in the value of the bonds they own.

Interest Rate Futures Example

Let's look at an example. Let's imagine you have a home loan of Rs 50 lakh, and you expect interest rates to rise in a particular length of time, say six months or a year, as a result of RBI policy. When interest rates rise, your EMI rises with them. You could sell an interest rate futures contract to mitigate the risk of rising EMIs as interest rates climb. If interest rates rise, the value of these futures contracts will decrease, and you will be able to repurchase them.

The higher EMI outlay is partially compensated by the difference in futures prices, and you are protected against the danger of rising interest rates.

Attributes of Interest Rate Futures

We'll look at some crucial elements now that we've looked at what interest rate futures are.

• The interest-bearing security where the contract is based on the underlying asset. It's either a Government bond or a T-Bill in the case of an interest rate futures contract.
• This is the predetermined end date for the contract's settlement in the future.
• This refers to the contract's total value. Trading in these futures, however, requires a minimum investment of Rs 2 lakh or 2,000 bonds.
• A minimum deposit is necessary to enter into a futures contract. You will be required to pay an initial or upfront margin to your broker when you begin trading. This serves as a security deposit, which must be submitted to the exchange by the broker. 
• The minimum margin for a cash-settled interest rate futures contract on the NSE is 1.5% of the contract's value on the very first day of trading, with a maximum of 2.8%. The margin for a 91-Day T-Bill futures contract is 0.10% of the futures contract's notional value on the first trading day. After that, it's 0.05 of the national value of a futures contract.

Benefits of Interest Rate Futures

Let's have a look at the advantages:

• Trading is more transparent because prices are disseminated in real-time.
• These futures work well as a hedging strategy. They're also good for risk management. You can mitigate your risk of shifting interest rates as a borrower by taking an opposite position in these futures.
• These futures are exempt from the security transaction tax, making them a cost-effective option.