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RBI introduces Interest Rate Option, effective from New Year

Economic Times:  December, 2016

Mumbai: In the new year, traders will have a new toy to play with as the Reserve Bank of India has introduced Interest Rate Option (IRO) effective from January 31 amid a bit of uncertainty over rate cuts in coming months.

With this banks, bond houses should be able to manage their interest rate risk better than earliar. Traders can also gain from it by speculating on interest rates. Nearly three years ago, Raghuram Rajan, former governor had introduced interest rate futures in the exchange traded platform, which has attained some maturity over a period of time.

“Eligible market participants are permitted to take positions in Interest Rate Options for their own balance sheet management and for market making purposes,” RBI said in a notification on Thursday.

“Banks and Primary Dealers (PDs) may act as market makers. Other regulated institutional entities can participate as market makers subject to the approval of their respective regulators.”

An option is a contract betting on future rate movement. But, there is a difference between Interest Rate Futures and IRO although both are based on rate action/expectation.

Under IRO, an option buyer’s losses are limited to the extent of premium paid while an option seller’s profits too are capped to the extent of premium.

“This will provide another avenue to market participants to hedge and speculate on interest rate risk,” said Naveen Singh, senior vice president at ICICI Securities. “This market too will evolve over a period of time in line with IRF market, which will too be impacted positively.”

Option writers often hedge their positions in futures market as well. In market parlance, it is called delta hedging, which helps get more maturity to the IRF market.

Exchanges may soon launch IRO platforms tapping business opportunities.

“Interest Rate Options are permitted on exchanges authorized by SEBI as well as in the Over-the-Counter (OTC) market,” RBI said.

“Exchanges shall obtain prior approval of the Reserve Bank before introducing any Interest Rate Option.”