NISM Series V-D · Chapter 19: Interest Rate Derivatives

L1 · Foundation

Foundation — What a derivative is, and the four interest rate products

The accounting definition of a derivative and its three tests, the legal definition under the SCRA, the four approaches to risk, the economic functions derivatives serve, and the four generic products applied to interest rates — FRAs and bond forwards, interest rate futures, options and swaptions, and interest rate swaps.

15 min read · Worth 1% of the paper · Written from pages 496–511 of the official NISM workbook · Updated 17 September 2026

19.1 What a derivative is

"Derivative is something that is DERIVED FROM another thing called THE UNDERLYING. The underlying is INDEPENDENT, and the derivative is DEPENDENT on and derived from the underlying. THE DERIVATIVE CANNOT EXIST WITHOUT THE UNDERLYING".

The three accounting tests

"accounting standards like FAS 133 (in the US), IAS 39 (in the EU) and AS 30 (in India) impose more qualifications... IAS 39 and AS 30 require the following THREE CRITERIA:

Value of derivative is LINKED TO THE VALUE OF UNDERLYING.
Trade settled on a 'FUTURE' date.
On trade date, there should be NO FULL CASH OUTLAY".

"FAS 133 requires an ADDITIONAL qualification: 4. Trade must settle (or capable of being settled) ON NET BASIS AND NOT ON GROSS BASIS".

What each means: the first "implies that the price of derivatives is determined by THE PRICE OF UNDERLYING, and NOT by the DEMAND-SUPPLY FOR DERIVATIVE. THE UNDERLYING IS THE RAW MATERIAL AND DERIVATIVE IS THE FINISHED PRODUCT". The second means "the settlement of the derivative MUST BE LATER THAN THAT FOR UNDERLYING — if the underlying settles T+2, the derivative must settle later than T+2". The third "provides 'LEVERAGE': ability to BUY the underlying WITHOUT FULLY PAYING for it immediately or SELL it WITHOUT DELIVERING it immediately".

The legal definition

"With Securities Laws (Second Amendment) Act, 1999, Derivatives has been INCLUDED IN THE DEFINITION OF SECURITIES". Under the Securities Contracts (Regulation) Act, 1956, a derivative is:

"a security DERIVED FROM A DEBT INSTRUMENT, SHARE, LOAN, whether secured or unsecured, risk instrument or CONTRACT FOR DIFFERENCES or any other form of security".
"a contract which DERIVES ITS VALUE from the PRICES, or INDEX OF PRICES, of underlying securities".
"commodity derivatives".
"such other instruments as may be DECLARED BY THE CENTRAL GOVERNMENT to be derivatives".

And Section 18A: "contracts in derivative shall be LEGAL AND VALID if such contracts are: traded on a RECOGNIZED STOCK EXCHANGE; settled on the CLEARING HOUSE of the recognized stock exchange...; between such parties and on such term as the CENTRAL GOVERNMENT may... specify".

The five asset classes and four products

"Derivatives are classified into FIVE ASSET CLASSES: RATE, CREDIT, EQUITY, FOREX and COMMODITY. In each asset class, there are FOUR GENERIC PRODUCTS: FORWARD, FUTURES, SWAP and OPTION".

"Derivative products initially emerged as HEDGING DEVICES against fluctuations in COMMODITY PRICES, and commodity linked derivatives remained the sole form of such products for almost THREE HUNDRED YEARS. FINANCIAL DERIVATIVES came into spotlight in the POST 1970 PERIOD due to GROWING INSTABILITY in the financial markets... by 1990s, they accounted for about TWO THIRDS of total transactions".

The four approaches to risk

"Derivatives are TOOLS TO MANAGE PRICE RISK. How you manage risk depends on YOUR APPROACH TO RISK".

Approach	Explanation
Speculation	"TAKING risk (more formally called 'trading'). It results in the possibility of positive return (i.e., PROFIT) or negative return (i.e., LOSS) in future"
Hedging	"You are ALREADY EXPOSED to risk and hedging ELIMINATES that risk and LOCKS IN THE FUTURE RETURN AT A KNOWN LEVEL"
Insurance	"You are already exposed to risk and insurance SELECTIVELY ELIMINATES THE NEGATIVE RETURN BUT RETAINS THE POSITIVE RETURN. It has an EXPLICIT UPFRONT COST, unlike speculation and hedging, WHICH DO NOT HAVE ANY COST. It requires a particular derivative called OPTION to implement it"
Diversification	"It REDUCES BOTH RETURN AND RISK but in such a way that RISK IS REDUCED MORE THAN RETURN so that risk is minimized per unit return"

The wheat example — both sides trade one risk for another

"A wheat farmer and a miller sign a contract to exchange Rs 10,000 for 100 kg of wheat after 2 months... The party agreeing to BUY the underlying asset in the future assumes a LONG position, and the party agreeing to SELL... assumes a SHORT position".

"The FARMER REDUCES the risk that the price of wheat WILL FALL below the price specified... and ACQUIRES the risk that the price WILL RISE above the price specified (thereby losing additional income that he could have earned). The MILLER... ACQUIRES the risk that the price WILL FALL below the price specified (thereby paying more in the future) and REDUCES the risk that the price WILL RISE".

19.1.1 The economic functions

"Though the PRIMARY economic role of derivatives is RISK MANAGEMENT, derivatives market also serves":

Hedging risk exposure — "an investor may purchase a derivative contract whose value moves in the OPPOSITE DIRECTION to the value of an asset the investor owns... profits in the derivative contract may OFFSET LOSSES in the underlying asset."
Price discovery — "Prices of derivative instruments such as futures and forwards can be used to determine WHAT THE MARKET EXPECTS FUTURE SPOT PRICES TO BE."
Market efficiency — "By using derivative contracts, one can REPLICATE THE PAYOFF of the assets. Therefore, the prices... TEND TO BE IN EQUILIBRIUM TO AVOID ARBITRAGE OPPORTUNITIES."
Access to unavailable assets or markets — "By employing INTEREST RATE SWAPS, a company MAY OBTAIN A MORE FAVOURABLE INTEREST RATE relative to interest rates available from DIRECT BORROWING."
Price stability — "many countries' central banks use derivatives for STABILISING THE CURRENCY PRICES. In India, RBI also intervenes in forex market through derivatives for INR STABILITY."
Higher volumes in the underlying — "the underlying market witnesses HIGHER TRADING VOLUMES because of participation by MORE PLAYERS who would NOT OTHERWISE PARTICIPATE for lack of an arrangement to transfer risk."
Speculation — "Financial derivatives are considered to be RISKY. IF NOT USED PROPERLY, THESE CAN LEAD TO FINANCIAL DESTRUCTION in an organisation. However, these instruments function as a POWERFUL INSTRUMENT for knowledgeable traders to expose themselves to CALCULATED AND WELL UNDERSTOOD RISKS."
Shifting speculation to the organized market — "Risk management mechanism and surveillance... in organized space PROVIDE STABILITY TO THE FINANCIAL SYSTEM."

The risks

"derivatives, being LEVERAGED INSTRUMENTS, have risks like COUNTERPARTY RISK (default by counterparty), PRICE RISK (loss on position because of price move), LEVERAGE RISK (magnifying the gain and losses), LIQUIDITY RISK (inability to exit from a position), LEGAL OR REGULATORY RISK (enforceability of contracts), OPERATIONAL RISK (fraud, inadequate documentation, improper execution)" — six risks here, one more than Chapter 13's list, the addition being leverage risk.

"and may not be an appropriate avenue for someone of LIMITED RESOURCES, TRADING EXPERIENCE AND LOW RISK TOLERANCE... Market participants... are advised to carefully read the RISK DISCLOSURE DOCUMENT, GIVEN BY THE BROKER to his clients AT THE TIME OF SIGNING AGREEMENT".

19.2 The four products, applied to interest rates

"Interest Rate Derivative (IRD) is a financial derivative contract whose value is derived from ONE OR MORE INTEREST RATES, PRICES OF INTEREST RATE INSTRUMENTS, or INTEREST RATE INDICES".

Generic derivative	Key feature	Market
Forward	"To buy or sell the underlying asset with cash for settlement on a future date. CUSTOMIZED contract"	OTC
Futures	"To buy or sell the underlying asset with cash for settlement on a future date. STANDARDIZED contract"	Exchange
Swap	"To buy or sell RETURNS from the underlying asset with RETURNS from other underlying asset/cash OVER A PERIOD"	Mainly OTC
Option	"A RIGHT to buy or sell an underlying with cash for settlement on a future date"	OTC and Exchange

And the interest rate row of the underlying-by-product grid: Forward → FRA and Bond forward; Futures → Interest rate and Bond futures; Swap → Interest rate swap; Option → Interest rate and Bond option, Swaptions.

Forward Rate Agreement

"FRA is an interest rate derivative contract that involves EXCHANGE OF INTEREST PAYMENTS ON A NOTIONAL PRINCIPAL AMOUNT, on a future date, at agreed rates, for a DEFINED FORWARD PERIOD".

"The party that is BORROWING money under the FRA has a LONG position, and the party that is LENDING money has a SHORT position. FRA contracts are usually CASH-SETTLED, that is, THE MONEY IS NOT ACTUALLY LENT OR BORROWED. Instead, the forward rate specified in the FRA is COMPARED WITH THE BENCHMARK RATE".

The first illustration: borrow Rs 100 crore after 60 days for 91 days at 5 per cent, settled against the 91-day T-Bill yield. If that yield turns out to be 5.5 per cent, "the long is able to borrow at a rate of 5%..., which is 0.5% LESS than the market rate. Total saving... = 100 Crores × 0.5% × 91/365 = Rs 12.46 lacs". But: "the settlement in FRA is on a CASH basis, and settlement takes place on a PRE-DECIDED DATE. But the saving above is AFTER the duration of the loan... So, THE PRESENT VALUE of the expected savings needs to be calculated".

The second illustration — a 3 × 6 FRA, "a contract starting in 3 months and ending in 6 months": notional Rs 10,00,000, FRA rate 5 per cent, floating rate at settlement 6 per cent.

Interest rate difference: 6% − 5% = 1%.
Interest amount difference: (10,00,000 × 1% × 3) ÷ 12 = Rs 2,500.
"Since FRA settles today, the cash settlement is discounted": Settlement Amount = 2,500 ÷ {1 + (6% × 3/12)} = Rs 2,463.05.

Bond forwards

Under the RBI (Forward Contracts in Government Securities) Directions, 2025, dated 21 February 2025:

"Bond forward means a RUPEE INTEREST RATE DERIVATIVE CONTRACT in which one counterparty (BUYER) agrees to buy a SPECIFIC GOVERNMENT SECURITY from another counterparty (SELLER) on a SPECIFIED FUTURE DATE and at a price determined at the time of the contract. Hence, underlying for bond forward can be GOVERNMENT SECURITIES ONLY."
"A RESIDENT; and A NON-RESIDENT who is eligible to invest in Government Securities... are eligible".
"Certain entities like BANKS, PDs are allowed to undertake transactions... as MARKET-MAKERS".
"Any entity, eligible to be classified as a NON-RETAIL USER... shall be eligible... as a USER".
"A bond forward transaction may be PHYSICALLY-SETTLED or CASH-SETTLED. A cash-settled transaction may be settled bilaterally or through any clearing arrangement approved by the Reserve Bank. A PHYSICALLY-SETTLED transaction shall be settled through the CLEARING CORPORATION OF INDIA LTD. (CCIL) or any other approved arrangement".

Interest Rate Futures

"IRF are STANDARDIZED interest rate derivative contracts traded on a RECOGNIZED STOCK EXCHANGE to buy or sell a NOTIONAL SECURITY or any other interest-bearing instrument or an INDEX of such instruments or interest rates at a specified future date, at a price determined at the time of the contract. Interest Rate Futures ALSO INCLUDE MONEY MARKET FUTURES".

Interest rate swaps and swaptions

"Interest rate swap is a derivative contract that involves EXCHANGE OF A STREAM OF AGREED INTEREST PAYMENTS on a 'NOTIONAL PRINCIPAL' amount during a specified period. Such contracts generally involve exchange of a 'FIXED TO FLOATING' or 'FLOATING TO FLOATING' rates of interest".

The chapter's worked swap: A pays Overnight MIBOR and receives fixed 3.75 per cent; B does the reverse; tenor 1 month, notional Rs 100 crore, 32 days.

Interest payable by A (floating, daily compounded): Rs 31,58,169.
Interest receivable by A (fixed): 100 crore × 3.75% × 32/365 = Rs 32,87,671.
Net pay-off for A: Rs 1,29,503; for B: (Rs 1,29,503).

"A SWAPTION is an OPTION ON SWAPS... A CALL swaption gives the holder the right to enter an interest rate swap where they RECEIVE A FIXED RATE AND PAY A FLOATING RATE, acting as a 'RECEIVER'. A PUT swaption gives the holder the right to enter an interest rate swap where they PAY A FIXED RATE AND RECEIVE A FLOATING RATE, acting as a 'PAYER'".

And credit default swaps

"One counterparty in the CDS contract (the 'BUYER OF PROTECTION') makes a REGULAR PERIODIC PAYMENT to the other counterparty (the 'SELLER OF PROTECTION'); in exchange the protection seller agrees to PAY THE PROTECTION BUYER ANY LOSS IN VALUE on the specified reference obligation IF A 'CREDIT EVENT' (e.g., default) WERE TO OCCUR".

Think of it like this

Raw material and finished product

The cleanest image in the chapter for why a derivative price follows its underlying: "THE UNDERLYING IS THE RAW MATERIAL AND DERIVATIVE IS THE FINISHED PRODUCT. If the underlying price goes up (or down), the derivative price will go up (or down) REGARDLESS OF DEMAND-SUPPLY FOR DERIVATIVE." Wheat flour costs what wheat costs, whatever the queue at the flour mill. This is the first of the three accounting tests — value linked to the underlying — and it is why the rest of this module spends its time on bond prices, yields and durations rather than on the derivatives themselves.

Hedging is free; insurance is not

The four approaches differ in a way that decides which instrument you need. Hedging "ELIMINATES that risk and LOCKS IN THE FUTURE RETURN AT A KNOWN LEVEL" — it removes the bad outcome and the good one. Insurance "SELECTIVELY ELIMINATES THE NEGATIVE RETURN BUT RETAINS THE POSITIVE RETURN", and for that privilege, "it has an EXPLICIT UPFRONT COST, UNLIKE SPECULATION AND HEDGING, WHICH DO NOT HAVE ANY COST. IT REQUIRES A PARTICULAR DERIVATIVE CALLED OPTION to implement it." You cannot keep the upside for nothing — that is exactly what an option premium buys.

Both sides of the wheat contract swap one risk for another

The farmer is not simply made safe. "The FARMER REDUCES the risk that the price WILL FALL... and ACQUIRES the risk that the price WILL RISE above the price specified (thereby losing additional income that he could have earned)." And the miller, exactly mirrored, "ACQUIRES the risk that the price WILL FALL... and REDUCES the risk that the price WILL RISE." Neither has eliminated risk; each has exchanged the risk he dislikes for the risk he can live with. That is what "hedging locks in the future return at a known level" really means — known, not necessarily best.

Everyone has interest rate risk; not everyone has the others

The chapter explains the dominance of interest rate derivatives in one sentence: "EVERY BUSINESS OR CORPORATION FACES INTEREST RATE RISK (and therefore need to use interest rate derivatives) while they NEED NOT NECESSARILY FACE OTHER RISKS like equity risk, currency risk... equity risk is faced ONLY BY INVESTMENT COMPANIES...; currency risk ONLY BY THOSE WITH EXPORTS AND IMPORTS; and commodity risk ONLY BY THOSE WITH EXPOSURES TO COMMODITIES." Anyone who borrows, lends, saves or holds a bond is exposed. That universality is why interest rate products dwarf everything else in the BIS numbers.

The borrower is long, the lender is short

Interest rate positions are named the opposite way round from what intuition suggests, and this is examined repeatedly. "The party that is BORROWING money under the FRA has a LONG position, and the party that is LENDING money has a SHORT position." Why? Because the borrower benefits if rates rise — he has locked a lower rate — so he is long the rate. The lender benefits if rates fall. Carry the mirror rule for bonds too: "the party that is BUYING the bond... has a SHORT position IN TERMS OF INTEREST RATE", since he expects yields to fall and prices to rise.

A swaption is an option on a promise

Layer the definitions and it becomes simple. A swap exchanges cash flows; a swaption is "an OPTION ON SWAPS" — the right, not the obligation, to enter one. The naming trips people up: a call swaption makes you a RECEIVER — "they RECEIVE A FIXED RATE AND PAY A FLOATING RATE" — while a put swaption makes you a PAYER — "they PAY A FIXED RATE AND RECEIVE A FLOATING RATE." Like booking an option on a rental agreement rather than the flat itself: you are buying the right to enter into a future arrangement at a pre-agreed rate, not the asset.

The FRA settles early, so the saving must be discounted

A detail candidates routinely miss. In the first example, the interest saving is Rs 12.46 lakh, but "the settlement in FRA is on a CASH basis, and settlement takes place on a PRE-DECIDED DATE. But the saving above is AFTER the duration of the loan... So, THE PRESENT VALUE of the expected savings needs to be calculated." The 3 × 6 example does the arithmetic explicitly: Rs 2,500 ÷ {1 + (6% × 3/12)} = Rs 2,463.05. Money paid now for a benefit that would have arrived three months later must be worth less. Any FRA answer that forgets the discounting is wrong.

Six risks, not five

Chapter 13 listed five risks in derivatives — counterparty, price, liquidity, legal or regulatory, and operational. This chapter lists six, inserting "LEVERAGE RISK (MAGNIFYING THE GAIN AND LOSSES)" between price and liquidity. It is a small addition with a large meaning: the very feature that makes derivatives attractive — "the ABILITY TO BUY THE UNDERLYING WITHOUT FULLY PAYING for it" — is itself listed as a risk. The same suitability test follows in both chapters: derivatives may not suit someone of limited resources, trading experience and low risk tolerance.

Key terms in this chapter

Bond forward: A rupee interest rate derivative in which the buyer agrees to buy a specific government security from the seller on a future date at a price fixed today. Underlying can be government securities only.
Bond swap: Selling one bond and simultaneously buying another with the proceeds. Theoretically two underlying bond transactions rather than a derivatives contract.
CCIL: Clearing Corporation of India Ltd, which offers CCP services with trade guarantee for many OTC interest rate derivative products in India.
Central Counterparty (CCP): The Clearing Corporation acting as common party to both sides, providing the trade guarantee, and protecting itself through margining and mark-to-market.
Counterparty credit risk: The risk of failure of the counterparty before the settlement date.
Credit Default Swap (CDS): The protection buyer makes regular periodic payments; the protection seller pays any loss in value on the reference obligation if a credit event such as default occurs.
Derivative: A contract whose value is derived from another thing called the underlying; it cannot exist without the underlying.
Diversification: Reduces both return and risk, but risk more than return, so risk is minimised per unit of return.
E-trading platform: Electronic communication networks in the OTC market that perform an exchange-like function for price discovery and trade execution.
Exchange-for-Physical (EFP): Another exchange facility offering customization, alongside RFQ.
Exchange-traded derivative (ETD): A screen-based order-matched contract settled with the aid of an Exchange and a Clearing Corporation. Standardized and more transparent, with no counterparty risk.
Expiry date: The standardized settlement date pre-determined by the Exchange.
FAS 133 fourth criterion: The US standard adds that the trade must settle, or be capable of settling, on a net basis and not on a gross basis.
Forward Rate Agreement (FRA): An OTC contract exchanging interest payments on a notional principal on a future date at agreed rates for a defined forward period. Usually cash-settled.
FRA settlement discounting: Because an FRA settles at the start of the loan period but the interest saving arises at the end, the difference is discounted to present value.
Hedging: You are already exposed to risk; hedging eliminates it and locks the future return at a known level. It removes the downside and the upside alike, at no explicit cost.
IAS 39 / AS 30 criteria: Three tests for a derivative: value linked to underlying; settled on a future date; no full cash outlay on trade date. AS 30 is the Indian standard, IAS 39 the EU one.
Insurance (as a risk approach): Selectively eliminates the negative return but retains the positive. It alone has an explicit upfront cost and alone requires an option to implement.
Interest Rate Derivative (IRD): A financial derivative contract whose value is derived from one or more interest rates, prices of interest rate instruments, or interest rate indices.
Interest Rate Futures (IRF): Standardized interest rate derivative contracts traded on a recognized stock exchange on a notional security, an interest-bearing instrument, or an index of such instruments or rates. They also include money market futures.
Interest Rate Swap (IRS): Exchange of a stream of agreed interest payments on a notional principal over a period, generally fixed-to-floating or floating-to-floating. The notional is never exchanged.
Leverage: The ability to buy the underlying without fully paying for it, or sell it without delivering it immediately. It flows from the "no full cash outlay" criterion.
Leverage risk: The risk of magnifying both gains and losses. It is the sixth risk listed in this chapter, one more than Chapter 13 lists.
Long position: The party agreeing to buy the underlying in future. In interest rate terms, the borrower is long — he gains when rates rise.
Market lot / Contract Amount: The standardized trade amount pre-determined by the Exchange.
Notional bond: Not a physical bond but a theoretical bond with fixed maturity and coupon, whose price is inferred from physically available market bonds.
Novation: The process by which buyer and seller transfer the original trade to the Clearing Corporation, which becomes the buyer to the seller and the seller to the buyer.
OTC derivative (OTCD): A privately negotiated and settled contract between two parties. Customizable, but carries counterparty credit risk and settlement risk.
Price discovery: Prices of futures and forwards reveal what the market expects future spot prices to be.
RBI Bond Forward Directions, 2025: Notification FMRD.DIRD.17/14.03.042/2024-25 dated 21 February 2025, governing forward contracts in government securities. Physically-settled trades must settle through CCIL.
Request-for-Quote (RFQ): An exchange facility offering customized contracts, narrowing the gap between exchange and OTC markets.
Risk Disclosure Document: The document given by the broker to his clients at the time of signing the agreement, which participants are advised to read carefully.
Section 18A of SCRA: Makes derivative contracts legal and valid if traded on a recognized stock exchange, settled on its clearing house, and between parties and on terms the Central Government specifies.
Securities Laws (Second Amendment) Act, 1999: The law that brought derivatives into the definition of Securities under the SCRA.
Settlement risk: The risk of default by the counterparty on the settlement date.
Short position: The party agreeing to sell the underlying in future. In interest rate terms, the lender is short — he gains when rates fall.
Single bond derivative: A derivative on a specific, real debt security, settled against its spot market price.
Speculation: Taking risk, more formally called trading. Results in possible profit or loss. No explicit upfront cost.
Swaption: An option on a swap. A call swaption makes the holder a receiver (receive fixed, pay floating); a put swaption makes the holder a payer (pay fixed, receive floating).
Underlying: The independent thing whose price drives the derivative. "The underlying is the raw material and derivative is the finished product."
Vanilla and exotic products: OTC market labels: vanilla means standardized products, exotic means customized ones.

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Original explanatory writing based on the official NISM workbook for Series V-D, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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