In a move to widen the ambit of the domestic capital markets, the Reserve Bank of India (RBI) on Thursday issued guidelines for the introduction of trading in interest rate options, effective January 31, 2017. While options trading has been in place in the equity market and was introduced in the commodities market in September, derivative trading with interest rates as the underlying has been limited to futures so far.
Trade in interest rate options will be permitted on exchanges authorised by the Securities and Exchange Board of India as well as the over-the-counter (OTC) market. Exchanges will have to seek prior approval from the RBI in order to enable trade in interest rate options.
The underlying for trade in interest rate options has not determined yet. “For orderly market development, Fixed Income Money Market and Derivatives Association of India (FIMMDA), in consultation with market participants, shall publish a list of objective and transparent rupee money or debt market rates or instruments that may be used as underlying for Interest Rate Option contracts in the OTC market and stock exchanges,” the RBI said in a notification.
Trades can be executed in simple European call and put options, interest rate caps, interest rate floors or collars. A European option may be exercised only on the date of the expiry of the option.
According to the notification, banks and primary dealers will be allowed act as market makers. Other regulated institutional entities will be able to participate as market makers, subject to approval from their respective regulators.
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All entities with an underlying interest rate risk will be eligible to participate in the market in order to hedge their risk. Participants will not be permitted to run net short positions in the interest rate options market.
Options are trading contracts where the buyer has the right but not the obligation to either buy or sellthe underlying asset at a price agreed upon in advance on a specified date in the future. The seller, known as the writer, is obliged to sell or buy the underlying under the same conditions.