Money Market Derivatives

Money Market Derivatives – providing the depth to the financial markets

A derivative security is a financial contract the value of which is derived from the value of an underlying asset. These assets may be stocks, currencies, interest rates, indexes, or commodities. Derivatives help manage various types of risks through hedging, arbitraging, and acquiring insurance against them. As they increase the capability of the markets to absorb risk, they enhance liquidity and reduce transaction costs in the markets for underlying assets. The deregulation of interest rates led to an interest tare risk. This risk is the adverse impact of interest rate movements on an institution’s net interest income and market value, dependent on the maturity profile of the assets and liabilities of the institutions as well as their repricing terms. This interest rate risk can be managed with the help of derivative instruments. Lack of money market derivative instruments will force banks to physically restructure their balance sheets by purchasing or shedding assets and liabilities, which might ultimately turn out to be insufficient. Derivative instruments are off-balance sheets which help banks to manage their interest rate risks without having to restructure their balance sheet and with more efficient use of capital. Hence, in July 1999, the reserve bank laid down guidelines to introduce two money market derivatives: interest rate swaps (IRS) and forward rate agreements (FRA). Both are under the counter derivatives. These contracts are negotiated between counter-parties and tailored to meet the needs of their contract. IRS and FRAs are new hedging instruments introduced to give more depth to the money market as also to enable market participants to hedge interest rate risk arising on account of lending or borrowings made at fixed/variable interest rates.

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