Interest rate is the price demanded by the lender from the borrower for the use of borrowed money. In other words, interest is a fee paid by the borrower to the lender on borrowed cash as a compensation for forgoing the opportunity of earning income from other investments that could have been made with the loaned cash. Thus, from the lender’s perspective, interest can be thought of as an "opportunity cost’ or "rent of money" and interest rate as the rate at which interest (or ‘opportunity cost’) accumulates over a period of time. The longer the period for which money is borrowed, the larger is the interest (or the opportunity cost). The amount lent is called the principal. Interest rate is typically expressed as percentage of the principal and in annualized terms. From a borrower’s perspective, interest rate is the cost of capital. In other words, it is the cost that a borrower has to incur to have access to funds.

Interest rates are typically determined by the supply of and demand for money in the economy. If at any given interest rate, the demand for funds is higher than supply of funds, interest rates tend to rise and vice versa. Theoretically speaking, this continues to happen as interest rates move freely until equilibrium is reached in terms of a match between demand for and supply of funds. In practice, however, interest rates do not move freely. The monetary authorities in the country (that is the central bank of the country) tend to influence interest rates by increasing or reducing the liquidity in the system. Broadly the following factors affect the interest rates in an economy:

There are individuals, companies, banks and even governments, who have to borrow funds for various investment and consumption purposes. At the same time, there are entities that have surplus funds. They use their surplus funds to purchase bonds or Money Market instruments. Alternatively, they can deposit their surplus funds with borrowers in the form of fixed deposits/ wholesale deposits. Interest rates receive a lot of attention in the media and play an important role in formulation of Government policy. Changes in the rate of interest can have significant impact on the way individuals or other entities behave as investors and savers. These changes in investment and saving behavior subsequently impact the economic activity in a country.

For example, if interest rates rise, some individuals may stop taking home loans, while others may take smaller loans than what they would have taken otherwise, because of the rising cost of servicing the loan. This will negatively impact home prices as demand for homes will come down. Also, if interest rates rise, a company planning an expansion will have to pay higher amounts on the borrowed funds than otherwise. Thus the profitability of the company would be affected. So, when interest rates rise, companies tend to borrow less and invest less. As the demand for investment and consumption in the economy declines with rising interest, the economic growth slows down. On the other hand, a decline in interest rates spurs investment spending and consumption spending activities and the economy tends to grow faster.

Different types of classifications of interest are possible. Based on how interest is computed, interest is classified into simple interest and compound interest. Simple Interest: Simple interest is calculated only on the principal amount which has not yet been paid. It is calculated by using the formula I = r x t x P, where I is the simple interest to be paid, r is the interest rate per annum, t is the time period expressed in years for which interest is being calculated and P is the principal amount not yet paid back. Note the difference between I and r. ‘I’ refers to interest income or simply interest, while ‘r’ refers to interest rate. It can be easily seen that the simple interest over 2 years on a given principal is equal to double the simple interest in one year; over three years, it is equal to three times the simple interest in one year and so on.

Compound interest arises when interest is added to the principal, so that the interest that has been added also earns interest for the remaining period. This addition of interest to the principal is called compounding (i.e. the interest is compounded). A loan, for example, may have its interest compounded every month. This means a loan with Rs 100 initial principal and 1% interest per month would have a balance of Rs 101 at the end of the first month, Rs 102.01 at the end of the second month, and so on. So, the interest in the first month is Rs 1, while the interest in the second month is Rs 1.01. The frequency with which interest is compounded varies from case to case; it could for example be monthly or quarterly or half-yearly or annually and so on. In order to define an interest rate fully, and enable one to comp are it with other interest rates, the interest rate and the compounding frequency must be disclosed.

Since most people prefer to think of rates as a yearly percentage, many governments require financial institutions to disclose the equivalent yearly compounded interest rate on deposits or advances. For instance, the yearly rate for the loan in the above example is approximately 12.68%. This equivalent yearly rate may be referred to as annual percentage rate (APR), annual equivalent rate (AER), annual percentage yield, effective interest rate, effective annual rate, and by other terms. For any given interest rate and compounding frequency, an "equivalent" rate for any different compounding frequency exists. Compound interest is explained with an example. Compound interest may be contrasted with simple interest, where interest is not added to the principal (i.e., there is no compounding). Compound interest is standard in finance and economics, and simple interest is used infrequently (although certain financial products may contain elements of simple interest).

One other way in which interest rates can be classified is in terms of fixed interest rates and floating interest rates:

If the rate of interest is fixed at the time the loan is given and remains constant for the entire tenure of the loan, it is called fixed interest rate.

Interest rates on commercial loans given to companies or individuals often fluctuate over the period of the loan. Also, loans may have an interest rate over the life of the loan linked to some reference rate, such as PLR (Prime Lending Rate), which varies over time.

For example, interest rate on a loan can be fixed at PLR plus 2 percent. As the PLR changes, the interest rate on the loan would change. In such cases, the interest rates are said to be floating rate, or variable rate.

Before understanding the concepts of present value, it is important to have a better understanding of compounding of interest. As stated earlier, the interest rate is usually quoted in terms of percentage per annum of the loans taken. For example, if a company borrows Rs. 100 crores and promises to return Rs. 106 crores at the end of one year, then the interest rate paid out is 6% per annum (p.a.). If on the other hand, this borrowing company borrows Rs 100 crores for say 3 years at the same 6 % p.a, but is required to pay interest only at the end of three years, he would have to pay more than Rs 118 crores. Interest Rate Futures (IRF): While the name ‘interest rate futures’ suggests that the underlying is interest rate, it is actually bonds that form the underlying instruments. An important point to note is that the underlying bond in India is a “notional” government bond which may not exist in reality. In India, the RBI and the SEBI have defined the characteristics of this bond: maturity period of 10 years and coupon rate of 7% p.a. The rationale behind using a notional bond is discussed in section 6.1.

It is also worthwhile noting that several other countries have adopted the concept of notional bond, although the characteristics of the notional bonds can and do vary from country to country. One other salient feature of the interest rate futures is that they have to be physically settled unlike the equity derivatives which are cash settled in India. Physical settlement entails actual delivery of a bond by the seller to the buyer. But because the underlying notional bond may not exist, the seller is allowed to deliver any bond from a basket of deliverable bonds identified by the authorities.

Like any other financial product, the price of IRF is determined by demand and supply, which in turn are determined by the individual investor’s views on interest rate movements in the future. If an investor is of the view that interest rates will go up, he would sell the IRF. This is so, because interest rates are inversely related to prices of bonds, which form the underlying of IRF. So, expecting a rise in interest rates is same as expecting a fall in bond prices. An expectation of rising interest rates (equivalently of falling bond prices) would therefore lead the investor to sell the IRF. Similarly, if an investor expects a decline in interest rates (equivalently, a rise in bond prices), he would buy interest rate futures.

It is not just the financial sector, but also the corporate and household sectors that are exposed to interest rate risk. Banks, insurance companies, primary dealers and provident funds bear significant interest rate risk on account of the mismatch in the tenure of their assets (such as loans and Govt. securities) and liabilities. These entities therefore need a credible institutional hedging mechanism. Interest rate risk is becoming increasingly important for the household sector as well, since the interest rate exposure of several households are rising on account of increase in their savings and investments as well as loans (such as housing loans, vehicle loans etc.).

Moreover, interest rate products are the primary instruments available to hedge inflation risk, which is typically the single most important macroeconomic risk faced by the household sector. It is therefore important that the financial system provides different agents of the economy a greater access to interest rate risk management tools such as exchange –traded interest rate derivatives.

Participants in the Interest Rate Futures market

The participants in the IRF market are broadly classified into three groups, depending on what is the purpose of their participation.

Companies and institutions having exposure to interest rates--because of their holdings of government bonds or their borrowing (liabilities) and lendings (assets)--hedge the risk arising from adverse interest rate movement by using IRF. These entities are called hedgers.

Speculators participate in the future market to take up the price risk, which is avoided by the hedgers. They take calculated risk and gain when the prices move as per their expectation.

Arbitrageurs closely watch the bond and futures markets and whenever they spot a mismatch in the alignment in the prices of the two markets, they enter to make some profit in a risk-free transaction.