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, 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.

1. Vanilla (Most Liquid, Least Complex)
2. Quasi Vanilla
3. 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

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