The Impact of Interest Rate Futures on the Underlying Interest Rate Markets in India

Abstract

If the market is perfect and complete, ideally, the introduction of derivatives should not in any way affect the equilibrium conditions in the underlying market.  However, the presence of information asymmetry in the market ensures that introduction of a derivative alters the speed with which equilibrium is attained.  This may generally affect the underlying asset’s price level and also its volatility. A study of a similar phenomenon is done in the case of the Indian bond market. The Indian Bond market which is predominantly G-sec saw the introduction of the interest rate futures recently.  The 10 year Interest rate futures contract based on a 10 year notional coupon bearing Government of India security, the 91 day T Bill futures which is based on 91 day T bills issued by the Government of India and the 2 and 5 year Interest rate Futures based on 2 and 5 year notional Gsec. The purpose of this paper is to understand their impact on the underlying market. The developments in the interest rate futures market can be attributed to the novelty of this market in India. In this paper we will try and understand whether there has been any change in the behavior of the markets for the underlying post the introduction of these derivatives. It is seen that both the short term interest rate and long term interest rate markets gets impacted on their turnover post the introduction of these derivatives. However, when it comes to volatility, it is only the short term interest rates which gets significantly impacted.