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.
- 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.