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Investing in Interest Rate Futures

Written By Briton Ryle

Posted January 21, 2014

Often times, the introduction of a new investment vehicle can increase market volatility, since investors have more places in which to put their money, thinning out the other markets.Indian Rupees Investing in Interest Rate Futures

But in India’s case, the commencement of interest rate futures trading on its Multi Commodity Exchange (MCX) on Monday and National Stock Exchange on Tuesday is expected to bring stability to the nation’s bond and currency markets, redirecting a lot of the heat and volatility away from bonds and the rupee toward IRFs.

When you stabilize currencies and bonds, you stabilize entire economies by stabilizing loans, mortgages, and the cost of money.

Thanks to interest rate futures, India’s banks will now be able to mitigate interest rate risk on their bond holdings without having to sell and buy back a single bond, while importers and exporters will be able to hedge the risk of currency exchange rates.

Given the huge volatility of India’s interest rates and currency exchange rates lately, the commencement of IRF trading this week will be a most welcomed relief.

Recent Instability

To understand why interest rate futures can be so useful to developing economies, we need only look to the enormous swings in currency values in 2013.

The trouble began May 1st, 2013, when the U.S. Federal Reserve began preparing U.S. markets for the eventual reduction, or tapering, of the Fed’s monthly bond purchases. They had no choice but to start talking about it early on, in order to take the bite out of tapering when it eventually happened in December.

Unfortunately, the preparatory discussion took a bite out of currencies around the world, since the reduction of stimulus strengthens the U.S. dollar, which in turn weakens other currencies relative to it. In India’s case, the rupee fell in value from 1.863 cents U.S. per rupee on May 1st to 1.467 cents by September 3rd – a loss of over 21 percent in just four months.

The weaker rupee made imports much more expensive, a crippling blow to a developing economy that imports expensive products while exporting only cheap ones. Inflation started to rise rapidly, from 4.58 percent in June to 7.52 percent by the end of 2013.

To make matters worse, foreign banks started pulling their investments out of India, selling bonds which drove up rates and the cost of money, with the interest rate on the government’s 10-year bond rising from 7.3 percent in June to 9.1 percent by year’s end.

This volatility in both the value of money (exchange rates) and the cost of acquiring money (interest rates) hit the banks as they take losses on their bonds, corporations as they pay more when raising money issuing corporate bonds, and international trade as companies pay more for their imports; and it’s always the consumer who ends up losing in the end.

The Interest Rate Futures Solution

The havoc that ripples through the economy disrupting banking, international trade and consumerism may begin with changes in foreign exchange rates which start the boat rocking. But the real culprit that ultimately tips the boat over is everyone’s reaction to those exchange rate changes.

They start trading bonds and currencies like crazy, exacerbating the volatility all the more. Banks don’t want to get stuck with bonds losing value, so they sell. Holders of the rupee don’t want to hold a depreciating asset, so they sell.

If they could trade some other interest rate instrument instead of actual bonds and currency, they could protect their holdings without compounding the problem through frenetic over-trading.

Well that’s what interest rate futures are all about – allowing you to trade just the interest rates themselves without having to touch your bonds or currency positions. IRFs now become a lightning rod that takes all the energy out of the storm, leaving your interest rate sensitive holdings fully protected.

If a bank believes interest rates are going to rise in the future, which would in turn cause bonds to fall, instead of selling its bond position at a loss and losing valuable interest income, the bank could simply sell interest rate futures.

When rates eventually rise in a few months’ time, the interest rate futures would have gained in value, offsetting part if not all of the losses incurred by the depreciation of the bonds. The IRF wins what the bonds lose.
In similar fashion, importers and exporters can protect themselves from adverse changes in exchange rates. If an importer believes the local currency will fall in value over time, it can sell IRFs to mitigate the reduction in the currency’s buying power.

IRFs and You

Of course, interest rate futures can also be traded for purely speculative purposes, as a simple bet for or against changes in value of the underlying instrument.

Currently, interest rate futures on India’s exchanges will allow you to trade the Indian 10-Year bond, as well as the major currency pairs of USD-INR, EUR-INR, GBP-INR and JPY-INR.

But to prevent over-speculation from disrupting the market, regulators at the Securities and Exchange Board of India (Sebi) are imposing a limit of $25 billion per investor. So if you were planning on investing $26 billion, you’re out of luck.

Still, it’s good to know that the introduction of interest rate futures in India’s markets will take some of the heat out of the bond and currency markets, which should help stabilize them and take some of the edge off the volatility.

Even if you as a foreign investor do not necessarily take advantage of these instruments, you can at least invest in India’s stock and bond markets as well as its rupee with a little more confidence now, knowing that IRFs are there to absorb any excess lightening strikes out of future Indian bond and rupee storms.

Joseph Cafariello