Interest Rate Derivatives

Chapter 2: Interest Rate Derivatives

NISM Series IV — Interest Rate Derivatives | ~5% weightage | ~20 questions

What this chapter is about

Conceptual bridge chapter. Derivatives definition, the three major economic functions, OTC vs exchange-traded, and why interest rate risk is the biggest risk for banks. Significant overlap with Series I (Currency) CH2 — same participant types, same derivative categories. IRD-specific additions: IRDs are regulated jointly by RBI and SEBI, interest rate risk is the most severe for banks and financial institutions, and the IRD market is the LARGEST derivatives market in the world.

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

| Feature | OTC (FRA, Swap) | Exchange (Futures, Options) | |---------|----------------|----------------------------| | Contract | Customized — perfect hedge possible | Standardized — basis risk | | Pricing | Bilateral negotiation between parties | Centralized market bids/offers | | Counterparty risk | Yes — bilateral | No — CC is central counterparty | | Accessibility | Not for all market participants | Widely accessible | | Settlement | Physical or bilateral cash | Cash (IRDs), may be physical (bonds) |

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