3. Intrest Rate Futures

8/8/2019 3. Intrest Rate Futures

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Forward Contracts and Forward

Rate Agreements (FRA)

Forward contracts for interest rate products areprivate, customized contracts between two financialinstitutions or between a financial institution and one

of its clients.

A good example of an interest rate forward productis a forward rate agreement, FRA.


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FRAs originated in 1981 amongst large London

Eurodollar banks that used these forward agreements

to hedge their interest rate exposure.

Today, FRAs are offered by banks and financial

institutions in major financial centers and are often

written for the banks corporate customers.

They are customized contracts designed to meet the

needs of the corporation or financial institution.


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Most FRAs do follow the guidelines established by

the British Bankers Association.

Settlement dates do tend to be less than one year (e.g.,

3, 6, or 9 months), although settlement dates going

out as far as four years are available.

The NP on a FRA can be as high as a billion and can

be drawn in dollars, British pounds and other

currencies.


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FRAs are used by corporations and financial

institutions to manage interest rate risk in the same

way as financial futures are used.

Different from financial futures, FRAs are contracts

between two parties and therefore are subject to the

credit risk of either party defaulting.

The customized FRAs are also less liquid than

standardized futures contracts.


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In five months the payoff would be

If the LIBOR at the end of five months exceeds the specified

rate of 6%, the buyer of the FRA (or long position holder)

receives the payoff from the seller.

If the LIBOR is less than 6%, the seller (or short position

holder) receives the payoff from the buyer.

? A)365/91(LIBOR1

)365/91(06.LIBOR

)M10($Payoff

!


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If the LIBOR were at 6.5%, the buyer would be

entitled to a payoff of $12,267 from the seller;

If the LIBOR were at 5.5%, the buyer would be

required to pay the seller $12,297.


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Interest rate futures

In case of interest rate futures the underlying assets will be differentinterest rate bearing instruments.

An interest rate futures contract is an agreement to buy or sell astandard quantity of specific interest bearing instruments at apredetermined future date and at the price agreed upon between theparties

The money lenders stand to lose if the interest rates go down infuture.

The money borrowers stand to lose if the interest rates go up infuture.

Of these contracts, the four most popular are

Short term Interest rate future contracts are

Eurodollar deposits T-bills

Long term Interest rate future contracts are T-bonds

T-notes


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Contract Exchange Contract Size

Treasury Bond

5-Year Treasury Note

Treasury Note

3-Month Treasury Bill

3-Month Eurodollar

1-Month LIBOR

Municipal Bond Index

3-Month Euroyen

10-year Japanese Government

Bond Index

Long Gilt

3-Month Sterling Interest Rate

CBOT

CBOT

CBOT

CME

CME

CME

CBOT

SIMEX

TSE

LIFFE

LIFFE

T-bond with $100,000 face value (or multiple of that)

T-note with $100,000 face value (or multiple of that)

T-note with $100,000 face value (or multiple of that)

$1,000,000

$1,000,000

$3,000,000

$1,000 times the closing value of theBond BuyerTM

Municipal Bond Index (a price of 95 means a contract size

of $95,000)

100,000,000 yen

100,000,000 yen face value

50,000 British pound

500,000 British pound

Futures Exchanges


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Main factors behind the growth of

interest rate futures

Enormous growth of the market for fixedincrease securities

Increased fluctuation in interest rates world

wide.


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Short term Interest rate future

contracts Eurodollar deposits

T-bills


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T-Bill Futures

Expiration months on T-bill futures are March, June,September, and December, and extend out about twoyears.

The last trading day occurs during the third week ofthe expiration month.

Under the terms of the contract, delivery may occuron one of three successive business days with thedelivered T-bill having a maturity of 89, 90, and 91days.


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T-Bill Futures

T-bill futures contracts call for the delivery (short

position) or purchase (long position) of a T-bill with

a maturity of 91 days and a face value (F) of $1

million. Futures prices on T-bill contracts are quoted

in terms of an index.

This index, I, is equal to 100 minus the annual

percentage discount rate, RD, for a 90-day T-bill:

( )R100I D!


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In futures contract, one tick means one basis point or

0.01%.

The minimum price change allowed is one basispoint.

For one contract it is $10,00000 * 0.01% * 3/12= $25

T- Bill Futures


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T-Bill Futures

Given a quoted index value or discount yield,

the actual contract price (purchase Price) on

the T-bill futures contract is:

{Index- (Discount rate * days tomaturity/360)}/100

Or {Face Value/ (1+ Yield Rate) * days to

maturity/365}

000,000,1$100

)360/90%(R100f D0

!


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T-Bill Futures

Example: A T-bill futures contract quoted at asettlement index value of 95.62 (RD = 4.38%) would

have a futures contract price (f0) of $989,050 and an

implied YTMof 4.515%:

YTM ={(Face value- Purchase Price) issue Price} * 360/ No. of

days to maturity Or (face Value/Purchase Price) 365/No. of days to Maturity -1

050,989$000,000,1$100

)360/90(38.4100f0 !

!

04515.1050,989$

000,000,1$YTM

1f

FYTM

91/365

f

91/365

0

f

!

-

!

-

!


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Another point of interest is the implied rapo

rate which is the rate of return on an annual

basis that yields if one buys a cash T-Billand sells a T-Bill futures at the same time.

IRR= (FPtT CPtT/CPtT) X 360/T-t

T-Bill Futures


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Example

18

E.g. a T-bill futures contract is priced with a discount of 8.25.

The futures price is observed as 100 8.25 = 91.75 (think of this91.75 as a price index and it is called the IMM Index)

The actual futures price is calculated as:

f = 100 [(100 IMM Index) (90 / 360)]

f = 100 [(8.25) (90 / 360)] = 97.9375

The standard contract size is $1,000,000

The futures price is $979,375

By assuming a 90-day bill in the formula

Each one basis point move in the IMM index corresponds to a $25

change in the futures price: 0.0001 x $1 million x 90/360 = $25

If the IMM index goes up to 91.76 (from 91.75), the futures pricebecomes $979,375 + 25 = $979,400


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Eurodollar Futures Contract

The CME's futures contract on the Eurodollardeposit has a face value of $1 million and amaturity of 90 days.

The expiration months on Eurodollar futurescontracts are March, June, September, andDecember and extend up to ten years.


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Like T-bill futures contracts, Eurodollar

futures are quoted in terms of an index equal

to 100 minus the annual discount rate, with

the actual contract price found by using thefollowing equation:

000,000,1$100

)360/90(100

f0

!


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Example, given a settlement index value of

95.09 on a Eurodollar contract, the actual

futures price would be $987,725:

725,987$000,000,1$100

)360/90(91.4100f0 !

!


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The major difference between the Eurodollar andT-bill contracts is that Eurodollar contracts have cash

settlements at delivery, while T-bill contracts call for

the actual delivery of the instrument.

When a Eurodollar futures contract expires, the cash

settlement is determined by the futures price and the

settlement price.


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The settlement price or expiration futures indexprice is 100 minus the average three- month LIBOR

offered by a sample of designated Euro-banks on the

expiration date:

Expiration Futures Price = 100 - LIBOR


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TED Spread

TED spread is the difference between the price of a3 month T bill futures contract and a 3 month

Eurodollar time deposit futures contract, both

expiring on the same day.


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Hedging interest rate with the

interest rate futures

1. Hedging a rise in interest rate (for

borrowing decision) or short term hedging

2. Hedging a fall in interest rate ( for

investing decisions ) or a long term hedging


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SyntheticH

edgingSpot Security+ future contract= Synthetic

Security

Eg- It is possible to create a synthetic T-bill

for a period of 6- months by

simultaneously investing in a 10 month cash

T-Bill and selling a 4 month T-Bill future.


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Strip and stackH

edging Buying various futures contracts with

different delivery times which are matching

the investor risk exposure date. Basis risk islow , liquidity is tight.

Buying various futures contracts which are

concentrated in the nearby delivery month.Basis risk is more but liquidity is high

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3. Intrest Rate Futures

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