Interest Rate Derivatives

NISM Series V-D | Chapter 19 | 2 marks out of 150

What this chapter is about

Study the concepts below for Chapter 19 of NISM Series V-D. This chapter carries 2 marks out of 150.

What is an Interest Rate Derivative?

A derivative where the underlying asset is the right to pay or receive money at a given interest rate.

Three categories:

• Bond derivatives: Underlying = a specific bond issued by a specific borrower (e.g., 10Y G-Sec futures)
• Interest rate derivatives: Underlying = an interest rate on money (e.g., Overnight MIBOR futures)
• Both are IRDs in common usage

All three are IRDs:

• Interest Rate Futures - standardized, exchange-traded
• Forward Rate Agreement (FRA) - OTC, customized, "forward on interest rate"
• Interest Rate Swap - OTC, exchange of fixed for floating cash flows, series of FRAs effectively

The largest derivatives market globally: Interest rate derivatives. As per BIS data, $500 trillion of $630 trillion total OTC derivatives is interest rate derivatives. Outstanding notional of OTC = 9 times exchange-traded.

Economic functions of derivatives

Three functions - all are correct: 1. Risk management / Hedging - PRIMARY function. Protect against price/rate/currency movements. 2. Price discovery - Futures prices reveal market expectations about future rates. 3. Speculation - Taking directional views to profit from price movements.

Role of underlying markets (primary markets) = FINANCING - transferring cash from who has it to who needs it.

Role of derivative markets = RISK MANAGEMENT

Who uses IRDs - three participants

Hedgers: Have real underlying interest rate exposure (e.g., bank with floating rate loans), use IRDs to REDUCE risk.

Speculators: No underlying exposure, take directional view on interest rates to PROFIT. Converting floating to fixed rate loan = hedging. Taking opposite bet on rates = speculation.

Arbitrageurs: Exploit price differences between markets (e.g., OTC vs exchange), zero directional risk.

Why interest rate risk is the biggest risk for banks

Banks borrow short-term (deposits) and lend long-term (loans/mortgages). This maturity mismatch means:

• If short-term rates rise (cost of funds rises) while long-term rates stay fixed → Net Interest Margin compressed
• Bond portfolio falls in value when rates rise

Interest rate risk > Currency risk > Equity risk for banks and financial institutions.

The risk faced by the HIGHEST NUMBER of market participants = Interest rate risk (everyone with a loan, deposit, or bond has it)

OTC vs Exchange-traded IRDs

OTC market is larger globally (9x exchange-traded in notional outstanding)

FRA provides more precise hedge than futures (customized maturity, amount) - but less accessible.

IRD Regulation in India - Joint RBI + SEBI

• RBI regulates: OTC IRDs, interbank market, IRDs in general (permission required from RBI for all IR derivatives)
• SEBI regulates: Exchange-traded IRDs (futures, options on bonds) on recognized stock exchanges
• RBI has delegated power to SEBI to define contract terms (lot size, expiry months etc.)
• Regulation is SIMILAR TO currency derivatives in jurisdictional structure

Participants permitted in IRDs (per RBI guidelines 2019)

• Residents (individuals, corporates, banks)
• Non-residents
• Retail and non-retail participants
• Banks: permitted for hedging and trading for own account - NOT on behalf of clients
• Insurance companies: permitted for LONG HEDGE only (not short hedge)
• Non-residents and FPIs: short position only for HEDGING, not speculation

Foreign Portfolio Investors (FPIs): Collectively can take net long position in IRF up to Rs 50 billion

Trap Alert

Trap 1: "Derivative markets provide financing" - FALSE Underlying/primary markets provide FINANCING. Derivative markets provide RISK MANAGEMENT.

Trap 2: "Banks can trade IRFs on behalf of clients" - FALSE Banks can trade IRFs for own account (hedging + trading). NOT on behalf of clients.

Trap 3: "FRA provides same precision as futures" - FALSE FRA = more precise (customized). Futures = standardized, so basis risk exists.

Trap 4: "OTC derivatives are smaller than exchange-traded" - FALSE OTC is 9 times larger than exchange-traded globally.

Trap 5: "Insurance companies can participate in short hedge" - FALSE Insurance companies = long hedge ONLY.

Trap 6: "Non-residents can short sell for speculation" - FALSE Non-residents and FIIs = short position for HEDGING ONLY.

Must-remember rules

• IRD underlying: bond derivatives = specific bond | IRDs = interest rate on money
• Biggest risk for banks = interest rate risk (not currency, not equity)
• Risk faced by most participants = interest rate risk
• Three economic functions: risk management (primary), price discovery, speculation
• FRA = forward on interest rate (OTC, customized)
• Swap = exchange fixed for floating (OTC, series of FRAs)
• OTC > Exchange by 9x globally in notional outstanding
• FRA more precise | Futures more accessible
• Joint regulation: RBI (OTC) + SEBI (exchange-traded)
• Banks: own account only (not clients)
• Insurance cos: long hedge only
• Non-residents, FPIs: short position for hedging only, not speculation
• FPI net long limit = Rs 50 billion in IRF

Quick revision - 60 second scan

• IRD market = largest derivatives market globally
• OTC 9x larger than exchange-traded
• Risk management = primary economic function of derivatives
• Banks biggest risk = interest rate risk
• FRA = forward on IR (OTC) | Swap = fixed/floating exchange (OTC) | Futures = exchange-traded
• RBI (OTC) + SEBI (exchange-traded) jointly regulate IRDs
• Banks: own account only | Insurance: long hedge only | FPI: hedge only, Rs 50bn limit