Interest Rate Derivatives
Interest Rate Derivatives are used to manage exposure to changes in interest rates and bond yields. The exam tests the inverse price-yield relationship, interest rate futures and hedging logic.
Core rules
- Bond prices fall when yields rise, and rise when yields fall.
- Interest rate futures (IRF) are exchange-traded contracts linked to a notional government bond; they are cash-settled.
- Interest rate swaps exchange fixed and floating interest payments; they trade in the OTC market.
- Duration measures sensitivity: approximate price change ≈ −duration × yield change.
- IRF margins and MTM are handled like other exchange-traded derivatives.
- Hedgers use IRF to offset bond-portfolio or borrowing-cost risk.
Worked example
A bond portfolio worth ₹10 crore has modified duration of 5. Yields rise by 0.50%. Approximate price change = −5 × 0.50% = −2.5%, so the loss is about ₹25 lakh. To hedge, the manager sells IRF whose notional value and duration match the exposure. The reasoning: duration converts a yield move into an approximate percentage price move; the hedge is sized on rupee duration, not just face value.
Traps that cost marks
- Thinking higher yields raise bond prices.
- Confusing coupon rate with yield to maturity.
- Hedging face value without matching duration.
- Ignoring convexity for large yield moves.