Hedging interest rate risk in Indian scenario can only be performed through interest rate swaps and forward rate agreements. These are derivatives introduced by the Reserve Bank of India (RBI) on Indian interest rates in July, 1999. An Interest Rate Swap (IRS) is an agreement between two parties to exchange stated interest rate obligations for certain period, in respect of a notional principal amount. Forward Rate Agreement (FRA) is an agreement between two parties to exchange stated interest rate obligations for a forward period, the terms of which are decided at a present date on a notional principal amount. The interest rate benchmarks which have been more popular in the Indian context is a call money benchmarkNSE overnight MIBOR. These products are over the counter in nature and are traded only between inter-bank participants and larger corporates. Being over the counter in nature, counterparties trading such products need to set up credit limits on each other and hence, not traded amongst lesser credit corporates or even individuals. Apart from these basic products, there are no products that are used in the Indian context for hedging interest rates.

There are no regulatory constraints in the existing system. However, there does exist some regulatory overlap, if interest rate hedging products have to be popularized and more liquidity has to be imparted. Currently, interest rate futures are present as a product class, but the biggest participants (banks) that can make use of the same, can only hedge. On a government security portfolio which they have purchased, that means they can only sell futures and cannot trade them in the same way they can trade in the government securities. Given such a scenario, the RBI regulates the banks which are the dominant participants to trade such products and Securities Exchange Board of India (SEBI) regulates the exchange and markets which offer the platform for such trading.

Developing liquidity in these markets requires two fold actionone that the RBI allows banks to trade freely in such products and secondly, SEBI to allow more participants like Foreign Institutional Investments (FIIs), just like in equity markets. Other regulators like Pension Fund Regulatory and Development Authority (PFRDA), Insurance Regulatory and Development Authority (IRDA) etc., can also put in respective guidelines amongst their participants. Such exchange-based products will translate into liquid hedging products for interest rates and the retail investors can take the advantage of this. For e.g., a deep and a liquid interest rate futures market can be used to hedge a floating home loan borrower. Apart from this, RBI can also take active steps to introduce other interest rate hedging tools like interest rate options, as per the Jaspal Bindra Committee Report (2003) on Interest Rate Derivatives. Today, banks are very savvy on hedging interest rate risk and they are well capable of using such products. Moreover, they are allowed to use such products with regard to their foreign currency borrowing. Thus, I believe that they would do well to hedge interest rates in the Indian context.

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