Market side rule

Before placing an interest rate derivatives order, three things have to be decided: which instrument, how much, and which month. The market side rule answers the middle question in disguise — not "how much" but "which side of the trade."

The logic runs through one fact: bond prices and interest rates move in opposite directions. If you expect rates to rise, you expect bond prices to fall, so you want to be positioned to profit from — or at least not be hurt by — a fall. If you expect rates to fall, you want the opposite side.

Get the direction of the underlying rate right, and the market side rule tells you which side of the futures or options market to be on.

The workbook's selection table (Chapter 22, section 22.2):

The reason overnight MIBOR futures sit on the opposite side of the bond and T-Bill rows is that MIBOR futures are quoted directly in interest rate, not in bond price — so a rate-rise view means going long the futures (which are priced off the rate itself), while a rate-rise view on a bond means going short futures (because the bond's price falls).

For someone hedging rather than speculating, the market side is decided by the exposure, not by a view: a participant who plans to borrow money in three months is exposed to rates rising, so is already "long on interest rate" through that exposure and hedges by selling interest rate futures now.

A treasurer at a company expects the Reserve Bank of India to raise the policy rate at its next review, and the company plans to issue Rs 20 crore of commercial paper in two months.

Rising rates would mean paying more to borrow. That is the same as being "long on interest rate" through the exposure. Applying the market side rule, the treasurer sells GOI bond futures now.

If rates do rise, GOI bond futures fall, and the short futures position profits — offsetting the higher cost of the commercial paper issuance two months later. If, instead, the treasurer had mistakenly applied the "falling rate" side of the rule and bought futures, a genuine rate rise would generate a loss on the futures on top of the higher borrowing cost, doubling the damage instead of hedging it.

Chapter 22 (Strategies using Exchange Traded Interest Rate Derivatives), section 22.2, sets out instrument, market side and contract month as the three parameters for any hedging or trading decision, with this table as the reference for market side. Expect a question that gives a rate view or an exposure and asks whether to buy or sell futures, or buy a put or a call.

• Rate up means sell bond futures, not buy. The inverse relationship between price and rate is what trips candidates who reason from "I want to profit, so I buy."
• MIBOR futures work the other way round from bond futures, because they are quoted in interest rate itself rather than in bond price.
• For a hedger, the market side comes from the exposure, not from a personal view on rates. A borrower is automatically on the "rates will hurt me if they rise" side, whatever they individually expect.
• Getting the instrument right and the side wrong is still a losing trade. All three parameters — instrument, market side, contract month — have to be correct together.