demonstrate that the operator has money to honor his side of the bargain. As long as
interest is earned on margined securities, there is no cost of margin deposits. The
enterprises which are to take loans or place their cash on some future date may prefer to
lock in the interest rate today itself to guard against unfavorable rate movements in the
interim period.
When interest rates rise, the price of an interest rate future comes down. The risk of rise
in interest rates is covered by selling futures contracts. The enterprise that wants to cover
itself against rise of interest rates sells contracts for an amount and a duration equivalent
to the position that it wants to cover. If a rise does take place, the gain that the enterprise
would have by repurchasing at a lower price the contracts that it had sold compensates
the loss resulting from the rise in the rate.
When interest rates fall, the price of an interest rate future increases. The risk of fall in
interest rates is covered by buying futures contracts. The enterprise that wants to cover
itself against fall of interest rates buys contracts for an amount and a duration equivalent
to the position that it wants to cover. If a fall does take place, the gain that the enterprise
would have by reselling at a higher price the contracts that it had bought earlier
compensates the loss resulting from the fall of the rate.
- Risk from Rise in Interest Rates.
This is the risk to which one exposed:
1) The enterprises which have taken a loan on a renewable rate or on a roll over
basis;
2) The enterprises that have to borrow in future.- Advantages of Interest Rate Futures
Interest rate futures are an efficient means of reducing the risks of rates and also for
obtaining better results. Interest rate futures are used to:
- Reduce the effect of rate variations on balance sheet items, for example, an
enterprise that has borrowed at a fixed rate and wants to benefit from a fall in
rates; - Reduce the impact of rate fluctuations on anticipated positions; this, in turn
ensures the business unit a more certain borrowing rate or a rate of return on its
fixed income securities. - Arbitrage between the future market and spot market.
In brief, future market provides a great deal of latitude and security to operators an
important feature of this market.