After makeover, interest rate derivatives begin catching up with other segments

Interest rate derivatives are slowly catching the fancy of market participants as trading volumes steadily rise. It’s been a slow but sure victory, because the product struggled to find takers for over a decade and went through regulatory makeovers twice.

In FY15-16, the total turnover in the interest rate derivatives segment registered an increase of nearly 40 per cent, according to data published in the annual report of capital market regulator SEBI. On the NSE, the annual turnover moved up to ₹5.26-lakh crore in the fiscal, compared to ₹4.21-lakh crore in 2014-15 and just ₹30,173 crore the year before. Volumes have also been steadily rising on the BSE and on the Metropolitan Stock Exchange.

A derivative is a financial instrument that derives its value from an underlying security. In the case of an interest rate derivative, the underlying is the interest rate (of a particular government bond, treasury bill, etc) and investors of that security protect themselves against unfavourable volatility by trading in such derivatives.

NS Venkatesh, Executive Director, Lakshmi Vilas Bank, explains it this way: “Let’s say you hold a 10-year government bond. In this case, the risk you face is of interest rates rising over time, which would then make the value of the bond you hold depreciate. Investors hedge against such a risk by actively going short on the future.

‘‘So, if your worry comes true, the underlying bond might depreciate but your hedge will appreciate. So, to that extent, you have protection on your portfolio.”

The most actively traded interest rate derivatives are linked to the 10-year government security, right now the 7.59 per cent 2026 G-Sec. While many investors use the instrument as a genuine hedge for their investments, others trade on the futures without the instrument.

Huzan Mistry, Strategic Business Head – Currency and Fixed Income, NSE (where 80 per cent of the trades take place), said while interest rate futures is still a very nascent segment, “we are pitching it to MFs and insurance companies more aggressively and hopefully, will see more participation from them”.

Currently, foreign banks, the newer private sector banks and primary dealers (who are intermediaries between the government and investors in G-Secs) are the biggest users. But awareness and use are growing among other segments as well, Venkatesh added.

“More retail participation is driving growth in the interest rate futures market, especially among HNIs and small corporates. I think there is more awareness about the instrument now. Also, as floating interest rates become more popular, people would rather borrow at a floating rate and convert it to fixed rate using the derivative,” Venkatesh said.

Interestingly, the structure for interest rate derivatives that India uses is unique to the country. When the product was launched earlier in 2003 and 2009, the underlying was the interest rate of not a single bond but a basket of securities.

“But for the market to initially understand the product, it’s best to have a single bond future and cash settlement. The simplicity of this structure has made it more attractive,” Venkatesh said.

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