interest-rate-derivatives-th

Context: The Reserve Bank of India recently proposed to introduce interest rate derivatives products that would be accessible to both foreign investors and retail participants.

  • The proposed Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2020 are aimed at encouraging higher non-resident participation, enhance the role of domestic market makers in the offshore market, improve transparency, and achieve better regulatory oversight, according to the RBI.
  • It allows foreign portfolio investors (FPIs) to undertake exchange-traded rupee interest rate derivatives transactions subject to an overall ceiling of Rs 5,000 crore. 

Analysis

  • Interest Rate Derivatives (IRD) are contracts whose value is derived from one or more interest rates, prices of interest rate instruments, or interest rate indices. 
  • In simple words, it is a financial instrument based on an underlying, the value of which is impacted by any change in the interest rates.
  • These may include futures, options, or swaps contracts. 
  • Interest rate derivatives are often used as hedges by institutional investors, banks, companies, and individuals to protect themselves against changes in market interest rates.

Types of Interest rate derivatives

  • In context to the degree of complexity, there are three types of interest rate derivatives, each of which can be distinguished based on the extent of liquidity, tradability and complexity.
  • A) Vanilla (Most Liquid, Least Complex)
  • B) Quasi Vanilla
  • C) Exotic derivatives (Least Liquid, Most Complex)

Advantages of Interest rate derivatives

  • They are more liquid compared to the underlying instrument
  • They help in lowering the cost of funding
  • Speculative positions can be taken in context to future movement in interest rates
  • They can provide yield irrespective of the market conditions
  • It helps in mitigating the risk from unpredictable interest rate swings (risk diversification instrument)

Disadvantages of Interest rate derivatives

  • Risk of loss is unlimited
  • Prices are generally not available publicly
  • Complex structure of the derivative can make it difficult to gauge the risk and calculate the yield.